How To Survive A Market Crash
No bullshit guide.
If you know me and have been following this publication for a while, you know that I am a net buyer of stocks over time. In the past 10 years, including all the corrections and crashes, I don’t remember any one-year period where I was a net seller of stocks.
This is because I think the key to success in investing is the ability to increase your ownership of wonderful businesses over time, not trying to buy them when they are cheap and dump them when they are expensive.
This is what Warren Buffett also does—“I have been a net buyer of stocks since I was 11”:
When the markets are cheap, you are going to find many businesses that are valued attractively; when the markets are expensive, you will still be able to find some hidden gems that are attractively valued, though they’ll be harder to find.
Thus, I have a natural tendency to buy regardless of the market conditions. Market conditions don’t dictate my behavior; valuations do.
You may now say—but you are talking about not deploying too much fresh capital in this market, how come?
That’s true; however, that’s not because I am afraid of a crash; it’s because I think some exceptional companies I already own may go on sale soon, so I want to have enough capital to buy more of them at attractive valuations.
That’s also what Buffett does.
He doesn’t build giant cash positions because he is afraid of market crashes; he builds them to be able to buy larger chunks of amazing businesses at a discount.
He builds large cash positions, then spends them generously in crashes. Look at this:
This is why I also have a natural tendency to always keep researching, always seek new opportunities, and write about them. This way, our community knows that the opportunity is there, even though we don’t buy it the next day, next week, or even next month, we know where to look when it’s time.
This week wasn’t going to be different; I was going to write about an opportunity I was tracking. However, reactions to market movements I saw in the last two weeks made me change my mind.
The market is down 1.5% in the last two weeks, and it’s only down just 2.7% from the all-time high.
Yet, I saw that people were panicking so much and asking questions like:
Why is the market dropping?
Is the market crashing here?
Is it time to exit the market?
We are just down 1.5%… Two weeks ago, this market was at its all-time high.
This overreaction led me to change my mind, and instead of writing a new deep dive, I decided to write about a market crash, how to prepare for a crash, and what to do when we are going through one of them.
So, I am going to try to do three things today:
Understand whether another crash is coming soon
Explain the reasons for overreaction to market movements
Share my sincere suggestions to prepare for a market crash
Let’s get started with the first one.
1️⃣ Is The Market Crash Coming?
If you have been following this publication for a while, you know that I always explain the unpredictability of the market and the impossibility of market timing.
We can’t time the market consistently; it’s impossible; however, we can understand where we are in the market cycle.
The market lives through successive cycles of booms and busts.
The reason is simple—human nature tends to take things to their extreme.
When I provide financial examples, people struggle to believe that it’s real human nature and applies outside of financial decisions, too. This is why I am going to give a very human example this time that is completely unrelated to finance.
Those who have children will get this in a second.
You put a few kids in a room and leave them to play. A few minutes later, they’ll start screaming and making unbearable noises. You rush to the room and tell them to be calm, make less noise. You leave the room and they’ll play in the dead silence for the next few minutes, then it’ll again be shouting and screaming.
You’ll either get a dead silence or screams, but never the ideal noise level you imagined, the one that will make playing fun for the kids without making life unbearable for you.
It won’t happen because people tend to take things to their extreme, both silence and noise; both optimism and pessimism.
That’s why we get booms and busts.
In a perfect world, it’s possible to never have booms and busts. Every actor is honest and perfectly rational. When a stock hits fair value, nobody else buys; when an index hits fair value, people look elsewhere for investment opportunities, etc..
In the real world, this is impossible to happen.
When people see an opportunity, they buy without regard to each other, and others who are late to the party always follow, thinking that there’ll always be a greater fool who will pay more. This way, a stock or an index quickly goes above fair value and shortly after reaches ridiculous valuations.
At this point, there are two options:
The market notices overvaluation itself and gets into a correction.
External factors push the market into a correction or a crash.
The first one happens occasionally. When a market drops around 10%, we deem it a correction. However, in the absence of external factors, recovery from corrections tends to be swift, and the market quickly becomes overvalued again.
Most of the time, the market needs other factors to fully deflate and return to normal valuations for a while.
That factor is generally the turning of the economic cycle, or the business cycle, some may call it. It’s a successive cycle of economic expansions and contractions:
Naturally, the peak of the cycle tends to be followed by the peak stock prices, while the market dips generally at times of depression.
We continuously get signals as to where we may be in the business cycle. There are three core metrics that signal where we stand:
GDP growth rate: It’s a straightforward indicator of what phase we are in, expansion or contraction.
Employment rates: High employment means there are more people in the economy who will create value, so expansion is more likely going forward.
Inflation rates: Low inflation means interest rates can stay lower, so credit will be cheap and economic activity will likely remain elevated, supporting economic expansion.
Employment and inflation rates are important and systematic drivers of the economic cycle, but they aren’t the only ones. There are an infinite number of unsystematic factors like supply and demand shocks, wars, natural disasters, plagues, etc.
Given that we can never foresee unsystematic factors, I always disregard them when I look at the business cycle.
When it comes to employment and inflation rates, it’s impossible to depend on them as their direction is more important than where they currently are; they tend to swing in a range for long periods, and they tend to move with a significant lag. So, I try not to depend on them too much.
What do I look at then?
There is one indicator that is reason blind but tells you more accurately where we may be in the business cycle—the credit spread.
It shows you how the actors in the economy currently feel, pessimistic or optimistic, regardless of the underlying reasons. It’s what I observe.
When the credit spread is low, it means that investors are demanding lower premiums to issue riskier credit, meaning they feel good about the economy. When the exact opposite is the case, it means they are pretty skeptical about the economy.
Therefore, when a low credit spread meets with record high valuations, it generally means we are close to the peak of the economic cycle. To the contrary, when high spread meets with dirt-cheap valuations, it generally means we are in a trough.
So, where are we standing today?
Let’s start with the market valuation:
As of the end of September, the market was valued at nearly 23x forward earnings against the 30-year average of just 17x. The Shiller P/E ratio was near 40. For reference, the last time Shiller P/E passed 40x, the dot-com bubble burst.
Looking at the numbers, it’s obvious that the market is overvalued. More than that, it’s now more richly valued than it was back in 2021, and it’s close to the valuations in late 1999.
Now, I know that there are many reasons this is not like 1999:
Companies dominating the index are the strongest that history has ever seen.
Those companies have better prospects due to accelerating growth driven by AI.
They aren’t as expensive as the leading companies of the dotcom bubble.
Let me be direct, I agree with all these. And beyond all these, I have several other reasons to feel more confident about the companies driving the rally today, such as their wide moats and impossibility to disrupt them in the medium-term.
However, relying too much on these differentiating factors necessarily results in saying “this is the new normal.”
I don’t know whether this could be the new normal or not, but what I know is that in nearly 250 years of market history, nobody who said this is the new normal ended up winning.
Thus, I would rather discredit myself and my thoughts, reminding myself that I am a human and I am foolable, and bet that this is not the new normal, regardless of what.
If this is not the new normal, the market valuation today is too stretched. There is no other way to see it. Either you should believe this is the new normal, or accept that it’s overvalued. I am in the latter camp.
So it’s settled, the valuations are pretty elevated.
What about the credit spread? It’s tight:
It’s currently standing at 3.09%. For reference, it’s been lower only earlier this year in the last decade. It was around 3.09% in December 2021, just before the crash of 2022 happened, and interest rates were still 0 at the time. Given that the interest rates are higher now, it wouldn’t be wrong to say that investors are now demanding unusually low premiums to lend to riskier borrowers.
In short, we have:
Extremely stretched market valuations.
Very tight credit spread.
To me, these two make it crystal clear that we are at or around the peak of this business cycle.
Does this mean the market will crash right away? Of course not. I don’t know how wide this peak is, or how long it will take for the economy to start cracking.
However, I know one thing: Even if nothing else goes wrong, credit spread staying very tight for a long time will lead to cracks in the economy.
The mechanism is simple:
When the spread is tight, it means credit is easy.
When the credit is too easy, it’s inevitable that unworthy people and businesses will also get credit.
At some point, unworthy will start to default.
When they start to default, the investors will step back, and those who relied on the consistent availability of credit will start going under, too.
When this happens, those high valuations will also come down as investors will pull their money out of the markets in fear.
In short, even if nothing happens and the current conditions continue exactly as they are, this market is doomed for a correction.
When will it happen? Impossible to time. However, looking at the past, the market took at most one and a half years to get into a correction once it reached the current valuations. In 1999, it went way higher before getting into a correction; in 2021, it hung around for a year before starting a decisive decline.
Thus, my bet is that it’ll likely happen within the next year, possibly toward the end of the year, as the dot-com crash matured in late 1999 and the 2022 crash matured in late 2021. Yet, it’s perfectly possible that it might have started last week; we can never know.
The question is, why are people so sensitive to the downward movements now, even if the valuations and the credit spread make it clear that a correction is due?
2️⃣ When You Eat Junk, You Know It
People who eat healthy and go to the gym tend to believe that they are healthy.
These people don’t easily use drugs; instead, they tend to wait out their pains. Even when they have chronic pain, it takes longer for them to suspect that they may have something serious because they know they took good care of themselves.
On the other hand, people who eat junk food and sit all day tend to panic when they feel the slightest pain. They are prone to taking medicines, and they are generally more worried about their health. It’s because they know that they didn’t take good care of themselves.
I think investors are a lot like these.
I have observed in the past 10 years that these groups tend to be overly sensitive and reactive to downside price movements:
Those who know they bought at elevated levels.
Those who don’t know what they own.
Those who are overinvested.
When they see the market go down, those people tend to ask questions that don’t have answers:
“Why is the market going down?”
“ Do you think it’ll go down more?”
“Does it make sense to exit here and buy again when it’s lower?”
First, let me remind you of the brutal truth—99% of the market movements don’t have any reason.
Take a look at the chart below:
Pagaya was trading at around $24 on November 7, and the earnings were scheduled for November 10, Monday. The company delivered blockbuster earnings, and the stock shot up to nearly $28.
It looks very simple, right? The stock shot up because it beat earnings, and investors revalued it and decided that the fair value was closer to $28. Perfect. If this is the case, can somebody explain why it declined to $24 in the next 3 days? No news, no events, no disclosures, nothing.
No particular reason. People sold their stock for a combination of quadrillion reasons that we can’t know. That’s it.
But this is not the main problem.
I can explain that daily price movements have no reason, that price doesn’t mean anything, and you should be detached, and all those things; however, these won’t pass to you if you know that you bought when it was expensive, or you don’t know what you own, or you invested your livelihood.
Let me give you an example.
When I first bought Nebius earlier this year, it was around $48, then it went to $25. When it dipped, we, as a community, doubled down on the stock, even tripled down. My average had settled somewhere between $20-25 before I averaged up at $70.
This stock is now down 40% from its highs of $141. Yet, it’s still around 3x from my initial average. Nobody whose average is around $30 or even $40 asks those questions without an answer like “how lower can it go?” However, those who bought the stock above $130 are asking those questions.
This is because they know that they might have overpaid. These questions are their responses to the panic they feel. They are trying to understand whether there is a way to save their money or if there is hope. This is why they are asking those questions. Nobody can answer these questions, and anybody who answers them with confidence is a fraud.
The formula is simple—you should avoid overpaying in the first place.
Think about it, as investors, we try to do two things:
Buy the best companies that we can see
Buy them at no-brainer valuations
Even when we are actively trying for that, many of our decisions will be wrong. When it’s already this hard, you are making it nearly impossible by taking the risk of overpaying. Let them go. Those you let go can’t make you lose money, and the pool of opportunities isn’t smaller because you let them go; it’s always infinite.
The second group of overreactors is those who don’t know what they own.
Investing is very simple in its essence. We just try to understand how much money the business will make in the future, what’ll be a reasonable multiple to pay for it, and what price we get when we discount what we find to the current day using the market return.
Those who don’t really understand what they own can’t actually foresee how much money the business will likely make in the future; thus, they don’t know what a reasonable price is to pay now.
If you don’t know this, you won’t be able to react appropriately to the price actions that happen for no reason 99% of the time, because that’s the only thing you can do now.
You can’t know what price the market will come up with tomorrow; you can only say that “I am going to buy when it’s below fair value, and stop when it’s above.” Thus, when the discount is larger, the appropriate action is to say “give me more”, not to panic, but if you don’t know what you own, this won’t be possible.
Peter Lynch bought Kaiser Industries at $14, and it went to $3.
What did he do? He only bought more because he knew what he owned. What did he get eventually? $50 a share:
I have held UnitedHealth from $250 per share in 2020 all the way to $600 a share earlier this year, and then watched it go from $600 all the way down to $250 a share again.
It’s the psychological equivalent of World War II. It’s not easy, and I am telling you that if you don’t know what you own, you’ll crack. You’ll start to get emotional with the company, you’ll get angry at them, and you’ll start feeling like they are denying you something you were entitled to.
That’s a destructive behavior. Of course, I felt stress, but in the end of the way, my guiding principles were clear:
Will this company likely make a lot more money 5 years from now? Yes.
Is the current price below what I think of as fair value? Yes.
Then I buy within the limits that risk management and portfolio construction allow me. More importantly, I definitely don’t panic sell. This is only possible because I know the business.
Imagine what would happen if I owned a stock of one of those nano-nuclear companies? I have no idea how much money they’ll make 5 years from now. So, if the position was in the money and went down sharply, I would be urged to exit as fast as possible to lock in the gains. If the position were flat and dropped sharply, I would be urged to exit and cut losses as fast as possible.
If you don’t know the business, you’ll be overly sensitive to any price movements, which will push you to make mistakes one after another. You have to know what you own, that’s non-negotiable.
The third group of overreactors is those who have their livelihood on the line.
It’s plain and simple, if your livelihood is line, you will almost always overreact and react emotionally to market movements.
If all of your hard-earned money is in the market, if you borrowed on margin, if you put your kids’ college money in the market, you’ll never be able to make the right decisions.
Bill Ackman explains it really well:
Imagine you put all your money into Nebius earlier this year, at $40 a share. If you held it up until now, you would have doubled your money. But what would you do when it dropped from $40 to $25? You would likely exit at $30 at a big loss.
I held it, not because I have some built-in calmness and superior willpower, etc. People will try to make you believe this bullshit: “I think I was built this way.”
Don’t believe that bullshit, they can hold because they are playing the game in the right way. They can hold because their livelihood isn’t on the line; I could hold because it was 3% of my portfolio, not 50%.
And again, don’t think this is special to financial decisions; this is basic psychology.
Any objective person would say 150 km/h is a reasonable speed on a German Autobahn. If you tell them they have their kid in the car, a reasonable speed would be 80 km/h, and you gotta drive on the right lane.
These three are the cardinal sins in investing, and they’ll break you even if you commit one of them. Yet, there are people committing all three of them at the same time. Imagine how destructive that would be.
These people overreact because they know they committed cardinal sins, just like people who overreact to a stomachache because they know they ate junk food. It’s not unreasonable; it’s thousands of years of evolution trying to keep you alive by urging you to take drastic measures.
However, if you want to make some money in the market, these won’t get you anywhere. If you have committed one of the cardinal sins, you should first clean that up; otherwise, you’ll only make mistakes one after another.
This brings us tangible principles of surviving a market crash.
3️⃣ How To Survive A Market Crash?
I think this question resembles very much the question of “how do I go to heaven?”
In every religion you can imagine, you’ll find detailed instructions for it. You do your deeds, keep your promises, be faithful and innately good, etc. However, before all this stuff, it starts with avoiding the cardinal sins.
Similarly, when it comes to weathering the market crashes, you’ll find many people giving technical and complicated suggestions, as people have a tendency to see them as bearing more expertise. Let me be clear, the more complicated it gets, the more bullshit it is. In every religion, if you avoid the cardinal sins, you’ll end up in heaven; it could be this simple.
It’s similar in investing; you avoid the cardinal sins, factors that make you oversensitive and overreactive to market movements, and the crashes will turn into opportunities for you.
First, you should look at your portfolio and your overall wealth. How allocated are you?
I don’t mean how much of your portfolio is in cash, I mean whether your living expenses for the next two years, possible emergency expenses, your kids’ college money, etc, are safe in the bank, earning a lazy 3.5%? If this isn’t the case, I guarantee you will end up losing money in a market crash. First, make sure of this.
Second, look at your portfolio. Do you really understand all the stocks you own?
Forget about me if you are subscribing to our portfolio, forget about anybody else whose ideas you like and rely on, look for yourself. Do you understand every business in your portfolio? Do you see everyone of them making more money 5 years from now? If you aren’t able to see this for yourself, you’ll never be able to do the right thing when the market crashes.
Third, is there a stock in your portfolio that you bought at elevated levels?
At this stage of the market, at least one such position exists for most people. Look at your portfolio, and be very honest with yourself. Is there such a position? If yes, let it go. Exit now. It could be in the red, and you’ll be tempted to wait for a better exit, but don’t fall for it.
As I have said, in 99% of the time, you’ll have a chance to make a better exit, but you’ll never know whether it’ll be tomorrow or two years later. And if it goes down 20% more before you get a better chance of exit, you’ll break and exit, incurring a higher loss.
Don’t fall for it.
Imagine you bought Google last week at $250 a share. What can you expect from it going forward? It was already trading at 25x forward earnings. Do you hope that it’ll go to 30x or 35x? This is not an investment thesis. Let it go; it can go to 35x forward earnings, and there’ll be some people who will benefit from that. You don’t need to be one of them.
Remember, clowns are the kings of a circus. When the market gets insane, ones who will make the most money will be the most foolish ones, not the smartest. I never recommend experimenting with being a fool.
It’s this simple: No chart, no portfolio theory, no bullshit is needed. Do these and you’ll survive a market crash.
You’ll even thrive in a crash because you’ll have a nice amount of dry powder to allocate to the companies that you really know and are trading at ridiculous valuations.
When you avoid the cardinal sins, you don’t need millions of good deeds to make up for them. Avoid the cardinal sins.
🏁 Conclusion
This market is ripe for a correction.
Looking at where we are in the business cycle and the valuations in the market, it’s obvious that this market is ripe for a correction. I don’t know whether it’ll be a mild correction or a hard crash, but we will have it.
Yet, I am not fearmongering about it. To the contrary, I am excited for a crash.
I have pretty low averages in the stocks that have driven the portfolio performance in the last three years. The stocks I am buying now are the ones that I believe are trading below fair value, so I don’t really care whether they go down more. There are some positions that I couldn’t allocate enough capital to before they skyrocketed, and I am excited to buy them at lower prices in a crash.
I have around 12% of my portfolio in cash. This is small compared to what Warren Buffett has in cash now (28%); however, it makes sense given that my risk appetite is much higher than that of Buffett. Still, I would like to increase this cash position to somewhere between 15-20%. If I can do that, I’ll feel better, but I already feel fine.
I can’t increase my cash position by much now, primarily because none of my positions are egregiously overvalued, and I feel confident to be a long-term owner for most of them. That’s a nice thing too.
This wouldn’t be possible if I didn’t have my livelihood for the next 2 years guaranteed in the bank, or I bought at egregiously high prices, or I didn’t know what I own.
If you committed one of those cardinal sins, it’ll be very hard for you not to overreact to price movements or keep calm in case of a market correction.
The point is straightforward: if you did one of those, or all of them, reverse them as soon as possible, before it’s too late. Then, you’ll find yourself reacting less emotionally to market movements and thinking more clearly. Once that happens, you are ready to survive a market crash.
However, if you insist on walking the sinner’s road, nothing will save you from a crash.
I hope this helps.
Excellent