Should I prepare my ISA for a stock market crash?

Could a stock market crash be on the cards? Dr James Fox explores whether this is a realistic probability and if his portfolio is prepared.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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Michael Burry, who famously made a fortune by predicting the collapse of the US housing market in 2008, recently made a $1.6bn bet on another stock market crash.

While that sounds scary, Burry has made several such bets or forecasts since 2008, and he’s been wrong. So should I get my portfolio ready for a stock market crash?

What is a crash-ready portfolio?

Preparing my portfolio for a stock market crash involves implementing strategies to minimise potential losses and safeguard my investments.

The first step would be diversification. This means spreading my investments across various asset classes, such as stocks, bonds, real estate, and even alternative investments like gold. Diversification helps reduce risk because different assets may react differently to market downturns.

Another step is avoiding risk assets. Instead, cash and bonds may offer insulation from a stock market crash. Additionally, I may want to consider using stop-loss orders or implementing trailing stop orders on individual stocks to limit potential losses.

What are the signs?

While it’s challenging to predict precisely when a stock market crash will occur, several signs and indicators may suggest that the market is at risk of a significant downturn. Keep in mind that these signs are not foolproof, and market conditions can change rapidly. Here are some common signs of a potential stock market crash:

  1. Overvaluation: When stock prices significantly exceed their intrinsic value, it may indicate a bubble that’s prone to bursting. High price-to-earnings (P/E) ratios and elevated price-to-sales (P/S) ratios are red flags
  2. Rapid Market Gains: If the market experiences an exceptionally rapid and sustained increase over a short period, it could be a sign of overheating. Parabolic price movements are often unsustainable
  3. Economic Indicators: Weakness in key economic indicators like GDP growth, employment rates, and consumer spending can foreshadow a market downturn. An economic recession can lead to decreased corporate profits and stock price declines
  4. Yield Curve Inversion: An inverted yield curve, where short-term interest rates exceed long-term rates, has historically preceded economic recessions and market crashes

Are the signs there?

Well, overvaluation certainly isn’t an issue among UK-listed stocks. All sectors of stocks here trade at a discount to their American counterparts, which suggests that there may be value to be found in the UK market.

Moreover, we appear to have come close to peak interest rates. When interest rates fall, it causes cash and debt to look less attractive versus shares, potentially making equities a more appealing investment choice. This could be an encouraging sign for investors looking to allocate their assets wisely in anticipation of changing market conditions.

Personally, I’m forecasting more upwards pressure on UK stocks assuming inflation data continues its downward trajectory. Of course, a geopolitical shock, such an escalation of the war in Ukraine, could send stocks into a tailspin.

However, it’s impossible to plan a portfolio around such an event.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Fox has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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