How to prepare for the next recession

The stock market has done quite well since 2008 financial crisis with very minor bumps along the way. 2017 alone has been one of the strongest bull runs in the recent history, with help of low interest rates and hopes of tax cuts from Washington. But this party will not last forever and if you are an active investor, you can take advantage of fluctuations in the market. There are a few strategies that we are going to focus on, and hopefully you will find some value in them.

Before Recession hits, take some profits!

If you have been in the market for the last few years, you should have made some money by now. The market has been generous and it has returned double the historical average this year (15% vs 7%). With valuations higher than average and a recent impressive return, do not be surprised if some big players start cashing out. The stock market is dominated by institutions and fund managers, and they can quickly turn the market around. But small investors have an edge, they can cash out anytime. If you have made a decent return so far, consider reallocating your portfolio while we are at the top. Yes you might miss out a little if the market continues to go up, but think of that as an insurance policy. If you are 80% in stocks and 20% in bonds, you might want to consider 60/40 or 50/50 allocations. You don't want to reallocate when we are in the middle of a 10-20% drawdown. Always remember that bulls climb the ladder, but bears jump out the window.

When market is dropping day after day, don't wait for it to go all the way down!

With all due respect to John Bogle and other buy and hold investors, you don't need to stay in stocks when they are down more than 5-10%. These is no way to time the market, that is for sure, but when your investment is shrinking you need to make a decision. What I am suggesting here is just my opinion and I am not a financial advisor, but there are ways to roughly predict if the recovery is significant or not. One way is to look at the VIX futures structure. If you go to VixCentral website, you can see the chart of VIX futures for each month on a graph. If current month is not lower than next month, that means a lot of people are buying put options and there is a lot of fear in the market. Remember, it took S&P 500 about 6 years to get back to where it was before crash in 2008.

Don't try to catch a falling knife!

This one is very important during corrections and recessions. Just because prices are falling, don't assume that you are getting a bargain. Prices can go lower, and lower, and even lower than what you expect. During financial crises, people need their money so they will cash out. Also, interest rates are already very low and Fed can't help anymore. Stock market doesn't have a fixed rule and valuations can stay low for a long time. Wait for the market to find a buttom then come back to the market. Missing out a bit is better than losing then gaining, because you don't know when the upward move is coming. Wait for the big money to enter the market, then jump in.

Be very careful if you want to play with VXX!

When everything goes south, a lot of investors will buy put options to prepare for drawdowns. That drives the VIX index up, sometimes in double digits in a day. If you are an active investor that can follow the market closely, you can benefit from these price hikes. Nothing is more satisfying than a 100% plus gain in a single day. But VXX (ETF that follows price action of VIX) can drop sharply too. I would never hold VXX overnight, because it can drop significantly before market open the next day. There are a ton of VXX strategies out there. Educate yourself and weigh the risk and reward. Believe me, long volatility trading is not for the faint of heart. And, this is a no brainer, but never buy VXX in anticipation of a market crash because you will lose money fast.

In a full blown selloff, don't buy 3x inverse leveraged ETFs, short the SPXL!

This one is for the time that market is on a nose dive, and you have conviction that it will go down much more. SPXL is a daily 3x leveraged bull S&P ETF. When market is falling, it falls 3 times the S&P every day. Shorting this ETF can provide much better results than going long leveraged inverse ETFs. There is a lot of spillage with inverse leveraged ETFs, and sometimes they just don't provide the results you are expecting. If you want to maximize your gains, you can even buy deep in-the-money put options of SPXL. That caps your return, but the premium on those put options will soar if market falls rapidly. I should also mention that short selling is much riskier than going long. Your potential for loss is unlimited when you take a short position, so be very careful if you want to take a short position against the market. Always use a stop loss and automatically recover your position if market went upwards. Don't get greedy while shorting the market!

Follow the economy and look for the sectors that get hit the most!

During the 2008 crisis, housing market and financials were the biggest losers. If back then you had short position in those sectors you could make a lot of money. During the 2000 bubble burst, Tech companies were the biggest losers. The area of the market that creates the crash is often the best opportunity to make money during the sell off. There are also consumer discretionary stocks, auto stocks, and leisure stocks that do poorly during market crashes, simply because people don't have enough money to spend it on unnecessary stuff. Pick a few overvalued stocks in these sectors and bet against them; they are the ones that drop significantly. Again, be very careful if you want to open a short position because the risk is huge if you get it wrong.

Finally, don't forget a few basics. Always put cash aside (not bonds, real cash), you don't know how bad the economy can get. Sometimes, having cash in a crisis can open unbelievable doors for you (think of the properties you could buy back in 2009). Be patient and do your homework. Making money during a crisis is not an easy task. A lot of things can go wrong, so fully study the position that you want to take and consider the worst case scenario. Also, remember that the crisis will be over and prepare yourself for the rebound. And last but not the least, if you are not an experienced investor, don't bother with short selling and options trading; not losing money is the first rule of investing. If you can avoid big losses, you have already won.

Disclosure: At the time of this publication I have no position in any of the ETFs mentioned. This publication is NOT intended as financial advice. Published statements are opinions only.