Is a Downturn Imminent and How Can I Prepare?

Earlier this week Bloomberg ran a headline titled “The Big Correction.” The piece cited predictions from several large banks that the S&P 500 may be headed for a drop. While financial media has a poor track record of calling downturns, the headlines raise two important questions:

Is a downturn imminent?
How can I prepare?

The Role of Uncertainty

If one word describes today’s market, it’s uncertainty.

This was reinforced for me recently when I had the opportunity to have dinner with the chief investment officer of well-known investment firm Doubleline. When I asked what he thought the next year might bring, his response was simple: “You don’t know, I don’t know, no one knows. There’s too much mixed data out there.”

This uncertainty may not be all bad Overconfidence has often been a warning sign in markets. In 1999 many believed tech profits would grow forever. In 2007 it was the conviction that housing prices could only go up. And in 2008, at the depths of the financial crisis, many felt sure the market would keep falling , right before it recovered. A healthy amount of humility about the future can help investors avoid costly mistakes.

Still, it’s worth looking at today’s data and valuations to understand where we stand.

Valuations and Market Conditions

Valuations give us a sense of how expensive stocks are relative to the profits companies generate. A widely used measure is the price-to-earnings (P/E) ratio, which shows how much investors pay for each dollar of company earnings.

At the end of last year, the S&P 500 traded at a P/E ratio of about 23, already above its long-term average. Today it is closer to 29, meaning stocks are even more expensive despite a number of challenges in the economy.

• Inflation has stayed higher than hoped, keeping interest rates elevated.
• Tariffs have been introduced that are expected to pressure company performance, even if not as severely as first feared.
• Labor market numbers are showing signs of weakness, with recent revisions moving in the wrong direction.
• U.S. debt and deficits are rising rapidly, raising concerns about long-term stability.
• Global investors are more hesitant to allocate money to the U.S., as its role as a reliable economic partner has come into question.

At the same time, optimism has been fueled by strong corporate earnings, favorable corporate tax treatment, and excitement about the potential of artificial intelligence to drive profits.

To boil this all down, fundamentals appear weaker than they were earlier this year while stock prices are higher. This combination usually points to lower expected returns in the years ahead.

That doesn’t mean a downturn is guaranteed. Valuations can remain high for long periods of time. What it does mean is that investors should double-check their financial readiness for when a downturn eventually comes.

How to Prepare for a Downturn

Instead of trying to predict when the market will fall, focus on making sure your financial plan can withstand it. The best time to prepare for a downturn is during market highs. Four key questions to ask yourself:

Do I have an adequate reserve?
A downturn is most damaging when you’re forced to sell investments while they’re down. Keeping 2 to 3 years of living expenses in low-risk assets such as cash, money markets, or short-term bonds provides a cushion that allows you to ride out volatility.

Is my portfolio aligned with my risk tolerance?
Every investor’s needs are different. Your portfolio should be balanced enough to weather a downturn but still aggressive enough to meet your long-term goals. In periods of high valuations, it can make sense to reduce risk slightly, often by shifting a portion from stocks to bonds.

Have I rebalanced recently?
When markets rise quickly, portfolios can drift away from their intended mix. Rebalancing restores the right balance of stocks and bonds and keeps your strategy disciplined.

Am I well diversified?
Avoid concentrating too much in a single asset class, company, or country. Broad diversification helps spread risk and provides stability during turbulent times. Being diversified does not keep your portfolio from dropping during a market downturn, but it does reduce your potential for volatility and permanent loss.

What to Do During a Downturn

If a downturn does occur, how you respond matters more than trying to predict it in advance.

Stay invested
Every market downturn in history has eventually been followed by recovery and new highs. The biggest mistake is selling while prices are low.

Take advantage of opportunities
Downturns can create attractive buying opportunities. Rebalancing into more stocks when markets are down or investing extra cash at lower prices can set you up for long-term gains.

Consider strategic moves
A downturn can also create opportunities for strategies like Roth conversions or tax-loss harvesting, which may improve your after-tax wealth over time.

Conclusion

No one can predict exactly when the next downturn will happen. What you can control is your preparation. By maintaining reserves, keeping your portfolio balanced, staying diversified, and avoiding emotional decisions, you can not only withstand volatility but also take advantage of the opportunities it brings.

Disclaimers

The views stated in this letter are not necessarily the opinion of Cetera Wealth Services, LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.

Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.

Rebalancing may be a taxable event. Before you take any specific action be sure to consult with your tax professional.

A diversified portfolio does not assure a profit or protect against a loss in a declining market.

Converting from a traditional IRA to a Roth IRA is a taxable event.