Our stock market as a whole is overvalued. Some individual stocks are undervalued but the market as a whole is overvalued. And guess what happens when the market gets overvalued? It deflates, i.e. goes down. It may not do it right away, it may take years, but it does decline. Now you’re looking at the last week thinking: is this the big drop? Well, you ain’t seen nothing yet.
The stock market doesn’t become bearish until it drops at least 20%. Have we dropped 20%? Last week the S&P declined 4% and the Nasdaq 100 declined 6%. Here are the largest stock market declines to put things in perspective:
1929 stock market crash – September 3rd 1929 the stock market started to decline and by November the stock market had lost more than half it’s value. It continued to lose value until 1932.
Monday October 19, 1987 – The Dow plunged 22%, the biggest one day decline in market history. By November most of the major indexes had lost more than 20%. The markets recovered completely by September 1989.
Dot com bubble early 2001 – The Nasdaq Composite Index had gained from 1000 to 5000 (4000 point gain) from 1995 to early 2000. From 2001 the Nasdaq dropped 76.81% by October 4, 2002. It took 15 years to recover its 2001 peak.
Financial crisis 2008 – From October 9, 2007 through March 6, 2009 the Dow lost 54% of its market value. It took 4 years to fully recover.
The nature of these kinds of crashes are they are unpredictable, except perhaps in hindsight. This is not to scare you, but to let you know to build cash as much as possible. But don’t get scared off by little declines. If you picked good stocks and the fundamentals are still good, you should be in good shape.
I’m not going to sell stocks to build cash but I will hold on to the cash I was going to invest. Of course I might make changes within my stock portfolio.
To refresh your memory a bit, you should have an emergency fund that you keep in a bank account of some sort, which should be able to cover 3-6 months worth of personal expenses. If you have a business you should also keep a similar amount for that. In addition, you should be building cash so that in the event of a serious market downturn you have the option to buy. You need a little dry powder.
When do you start using your cash to buy? Once the market declines to a bear market, you probably have about 18 months of bear market before the bull returns. So right away is probably not the right answer.
Make sure to check out this link, which is where I got many of my facts and figures: