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The Best Investing Strategy in a Market Crash

Nov 29, 2021

The Best Investing Strategy in a Market Crash

Have we entered a new bear market? No, not yet at least.

The commonly accepted definition is a minimum 20% fall from the top. After taking into account last Friday's brutal decline, the fall from the top currently stands at 8%.

So technically, we are not even halfway into entering a new bear market.

However, the events of the last few days have definitely scared investors. The shift from the euphoria of the Sensex touching an all-time high to disappointment around a handful of negative developments, is palpable.

Besides, this has been a one-way rally so far and therefore, a meaningful correction only seems par for the course.

My own view is a little pessimistic to be honest. I even put out a YouTube video on Saturday that showcasing three charts central to my negative outlook over the next 9-12 months.

And then, over the weekend, I went a step further and ran some numbers around the kind of stocks that can offer the best protection in the event of a meaningful correction.

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You see, the best way to figure out which stocks are affected the least in a bear market is to try and figure out their performance in a real bear market of the past...and this is exactly what I did.

I considered the bear market between December and March last year when the index was down almost 30% due to the Coronavirus pandemic.

I wanted to arrive at some broad conclusions that could be helpful in future bear markets.

Here's the first key takeaway...

When markets witness a huge correction, there is usually nowhere to hide.

More than 90% of all the category of stocks fell between January and March last year with the number slightly higher in case of mid and smallcaps.

So, if you thought some stocks offer safety even in the face of a big correction, it's perhaps time to rethink that view. Good luck finding those handful of stocks that will defy the broader market trend.

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By the way, for the purpose of this study, largecaps are the top 100 stocks by market cap, Midcaps are the next 150 stocks, and smallcaps are stocks ranked 251 to 550 by the same marketcap criterion.

Now, here's the decline by category...

No surprises here I guess.

There could be a few exceptions but as a group, largecaps fall less than midcaps which in turn fall less than smallcaps in a market crash.

So, if your portfolio is loaded with mid and smallcaps, perhaps it is time to re-think your asset allocation at the peak of a bull market.

How about this one...

I love momentum as a strategy. I love the idea of getting into a stock that has gone up the most because it will continue to go up.

However, I did not know that momentum stocks can outperform their category even in a bear market. At least this is what the data is indicating.

Discover: Why you should consider investing in 'Safe Stocks'

The top 20% stocks in each of the above category that have gone up the most in the last one year, have also lost less than their respective categories.

Ideally, stocks that have gone up the most in a bull market should also fall the most in a bear market. But thanks to the momentum effect, this doesn't seem to be the case. So, if you want to outperform in a bear market, momentum stocks could be the place to go.

Now, how about the opposite of momentum?

If a certain stock has not participated in a bull market and has mostly been a laggard, would you buy this stock if you knew a bear market was around the corner?

Logically you should, right? After all, this stock has gone up the least in a bull market and will therefore fall the least in a bear market.

Well, it may not be the most sensible thing to do as the chart above highlights. Biggest losers of the last one year are the worst stocks to be in when a bear market strikes. They end up underperforming their group by a big margin.

So, if you have a few underperformers in your portfolio, perhaps it is time to big them goodbye for now and maybe consider them again at the bottom.

It's common knowledge that we should invest in quality stocks. But how do you define quality? Well, to me, a company with almost zero debt is one of the useful quality indicators.

And this is exactly what I have done in the next chart.

The top 20% stocks in terms of their debt to equity ratio have done better than their respective categories and have suffered a smaller decline. Goes to show the power of this simple indicator. Investing in zero debt or low debt companies never disappoints.

Another surprise package are the High PE vs Low PE stocks (PE is calculated based on average EPS of last three full financial years).

One would think that low PE stocks would fall less in a bear market as they are already beaten down and high PE would underperform as high expectations are built into them and therefore, they would fall the most.

However, the figures reveal something entirely different.

It's the top 20% stocks with the highest PEs that have ended up outperforming their category. On the other hand, low PE stocks have done worse and have fallen more than the category as a group.

Perhaps the business quality of the low PE stocks is so dubious that everyone tried to get rid of them during a bear market.

So, there you are. A deep dive into the last bear market to understand the type of stocks and strategies that offer the best protection.

Here's what I could conclude with a reasonable degree of confidence.

  • If the crash is deep, everything goes down. There's hardly any pocket that offers safety.
  • Largecaps as a group falls less than midcaps and they in turn fall less than smallcaps.
  • Best performing stocks of the last year may continue to outperform in a bear market. Likewise for worst performing stocks. They may continue to underperform.
  • Quality in terms of low debt to equity ratio may offer a decent protection.
  • Contrary to popular perception, low PE stock don't always outperform high PE stocks. In a bear market, revers could be true.

Now, these are of course some broad pointers and should be used in conjunction with other stock specific parameters.

However, I believe they could still come in handy when deciding which stocks to sell and which to keep in case you're looking to book profits and take some money off the table.

Let me know what you think.

Happy Investing!

Warm regards,

Rahul Shah
Editor and Research Analyst, Profit Hunter

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