If a Market Correction Is Coming, History Says This Is the Smartest Investing Move You Can Make
Key Points
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The S&P 500 has doubled over the past four years, but AI spending is starting to worry investors.
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The Buffett indicator is already past a point where Buffett says investors are “playing with fire.”
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If the market crashes, you won’t be able to take advantage of great deals unless you have some cash ready.
The S&P 500 (SNPINDEX: ^GSPC) has enjoyed a tremendous run over the past four years, more than doubling in value (up 110%). Much of its rise is connected to artificial intelligence (AI), with companies like Nvidia and Palantir Technologies leading the charge, up 2,320% and 1,680% over that time, respectively.
That’s still happening, but the stakes are much higher now. Hyperscalers like Amazon and Alphabet are investing billions, and soon trillions, on AI, with the rewards yet to be fully seen. Both of those companies reported negative free cash flow in the second quarter, and both insist that the results will soon flow in.
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But as the market becomes more expensive, investors may not keep paying up for expectations. Take the Buffett indicator, for example, which Warren Buffett developed as an indication of how expensive the stock market is and whether or not it makes sense to buy stocks. The simple formula divides the total stock market value by the U.S. gross domestic product. Buffett explained: “If the relationship drops to 70% or 80%, buying stocks is likely to work out very well for you. If it approaches 200% as it did in 1999 and 2000, you are playing with fire.” Today, it’s at 297%.
That doesn’t mean a market crash is imminent, but it does mean that investors should be prepared for one. If a market crash is on the way, history suggests that this is the smartest move you can make.
How to benefit from market crashes
Believe it or not, you can benefit from market crashes. That’s when you can find amazing deals on top stocks, as long as you have some cash on hand to buy them. If you have to sell losing stocks to buy other ones, you’ll turn paper losses into real ones. But if you put aside some cash now, you’ll be ready.
Your portfolio should predominantly be made up of stocks you can hold for years or even decades. But if you own some high-growth stocks that have already appreciated in this bull market and could be at risk, now could be a good time to pocket some gains to have more cash. You might also need to rebalance your portfolio, which could involve selling even great stocks.
For example, if you invested in Nvidia a few years ago and it now represents an outsize portion of your holdings, that creates risk. You would want to sell some and be better diversified, and you might want to hold on to some of the cash to invest if there’s a market crash.
Consider the difference if you’d invested $10,000 somewhat before the most recent crash, in 2020, or at the bottom:
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Data by YCharts.
Data by YCharts.
That doesn’t mean you should stop investing today, because there’s no way to know when the top or bottom is. But you should make sure you’re also able to invest when stocks are under pressure.
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Jennifer Saibil has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Nvidia, and Palantir Technologies. The Motley Fool has a disclosure policy.