A Survival Guide for the Worst Market Crashes, Part 2

When I was considering the question of whether or not rate hikes mattered, I realized something even more profoundly simple.

Nothing actually matters in the financial markets, until it does.

I have seen stocks shake off rate hikes, wars, New England Patriots Super Bowl victories, ridiculous fiscal policies, and other sorts of calamities before calmly moving higher.

I have also seen markets that collapse on fears of currency moves, human error, and stupidity (the most common cause of market collapses).

We’ll never know what the market is going to say, but once it does speak, there are certainly tools you can use to decipher its message.

Personally, I prefer the toolkit outlined in Part 1: buying assets trading far below their fair value, waiting until they rise back to that fair value or higher, and selling them for a huge profit.

However, I know that while I may be a smart guy, I’m definitely not the smartest guy participating in the markets.

I have my own investing philosophy that’s worked well for decades, but I’m certainly not above freely stealing ideas from other bright investors if those ideas make me taller, better looking, or wealthier.

With that in mind, today I’ll show you two ways to hear what the market is saying, sidestep the worst market conditions, and generate huge windfalls as everyone else runs for the hills.

And these two methods happen to have been developed by the unlikeliest of investors – a California surfer and a former Marine…

Method No. 1: The Timing Model, Developed by a California Surfer

The first and simpler model of the two was developed by Mebane “Meb” Faber, who skied on Lake Tahoe and surfed in Manhattan Beach, Calif., before developing some of the most successful quantitative approaches to stock selection out there.

Faber’s unique approach – often called the “Timing Model” – centers on understanding that the real damage from bad markets doesn’t come from the price decline itself.

Instead, the real damage comes from investors’ psyches, which scare them into selling near the low when the pain from market sell-offs is just too much for them to bear. That same fear is what prevents them from getting back into stocks even when conditions have improved and it’s safe to do so.

His rules of capitalizing on these emotions are simple…

If the S&P 500 is above the 200-day moving average, buy stocks. If the S&P 500’s closing price on the last day of the month is below the 200-day moving average, sell stocks and hold cash. We only check the price-to-moving average on the last day of the month and ignore intra-month price movements.

By following these rules, you effectively ride the market higher when it’s already high, but hedge any downside by selling before the panic sets in.

Sticking to these parameters lessens the chances of getting whipsawed around by short-term market movement. In other words, it allows you to keep your sanity when everyone else is losing theirs.

The hardest part about this approach is having enough courage to actually stick with it. Unlike traditional money-management approaches, this type of asset allocation outperforms in big bear markets, but underperforms in multi-year bull markets since you don’t get back into stocks until the recovery is underway.

If you have the discipline to stick with it, this simple model can give you index-like returns without the excruciating pain of massive drawdowns.

Speaking of excruciating pain, this next risk-control model comes to us from a former Marine Corps captain whose idea of fun is strapping a 35-pound rucksack over his shoulders and trekking 28 miles through the hills of Pennsylvania…

Method No. 2: A “Military Model,” Developed by a Former Marine

The man in question is Wesley Gray, who served in Iraq and ended up becoming a leading thinker in the world of quantitative investing and risk control.

Like me, Wes is an idea thief when the occasion demands. And like Faber, he somewhat relies on a moving average for the first part of his two-part system, which essentially goes like this…

If the S&P falls below the 12-month moving average, one of his two signals is triggered, and a red light flashes for owning stocks. The second red light flashes if the S&P’s six-month performance minus the six-month return on Treasury Bills is less than zero.

If just one of them turns red, you reduce your exposure to stocks by 50%. If both of those lights flash red, you sell everything and go into cash.

When the S&P rises above the 12-month moving average and that math involving the six-month returns is greater than zero, both lights flash green. That means 100% of your portfolio should be in stocks.

It’s a simple approach that, like Faber’s, is also intended to provide index returns without the volatility and drawdowns that scare many individual investors.

For Even Better Returns, Follow This Aggressive-Patient Investor Approach

Both of these systems will help protect your money and your sanity from the gut-wrenching losses that can happen in a bear market. They provide a clear-cut decision about when to buy back into the market, thereby overcoming one of the most significant obstacles individual investors face after a period of falling prices.

While everyone – including myself – has their own methods, there’s no doubt both Gray and Faber have designed models that let you hear the market speak. You can ignore all the day-to-day noise of the media and only listen when the market tells you something important.

But a critical thing to understand is that these approaches are heavily risk-averse. At best, they’ll provide you index-like returns, and at worst, they’ll provide a nice hedge against a market apocalypse.

If you crave returns that are much higher than that, you need to adopt the approach mentioned in Part 1, which I’ve honed over the last 40 years: the aggressive-patient investor approach focused entirely on buying companies at bargain prices.

— Tim Melvin

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Source: Money Morning