How to invest for a crash

I believe there is a correction coming and potentially much more than a correction. While nothing is guaranteed, we could be lining up for a 1987-style market crash, with all that entails (though a crash is not guaranteed, either). If we see such an event, I doubt foreign stocks will be spared in the short term.

But when will the correction/crash come? I don't know and neither does anyone else.

Here and now, the bulls are practically baying at the moon. Everything seems to be going up and up (except government inflation numbers). Bears have gotten trampled. There is talk of global slowdown, but the reality hasn't taken hold just yet. Copper, otherwise known as 'Dr Copper' or 'the metal with a Ph.D. in economics, is rolling along at historic highs. Steel stocks, sensitive to industrial demand, are carving out new highs too. Liquidity channelers like Goldman Sachs are at the absolute peak of their earnings cycle making more in the most recent quarter than in the entire 2002.

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Ominous signs are also building: Protectionist sentiment is on the rise, even more so in Europe than in the United States. The housing bubble hasn't popped, but it is clearly hissing. The consumer-spending gas gauge is moving closer to 'E,' with mortgage resets looming. Long bonds are breaking down. The Middle East situation is fraying badly at the edges (and Middle Eastern markets have already crashed). Emerging markets in general look vulnerable.

The bulls are in control, but the vanquished bears have an airtight case: At some Point, the credit-driven liquidity boom has to end, and it will likely end badly.

Still, it could be six days, six weeks or six months before things come apart at the seams. Our markets could be even higher at that point much higher. And who knows how energy and metals will respond to stepped-up global turmoil? Depending on the circumstances, it could help as much as hurt, even with the walls falling down all around.

So what do we do in these turbulent times? Should investors wait?

Investing for a crash: choose a plan and stick to it

First, work from a long-term thesis. Second, work out a plan and stick to it.

The thesis regarding precious metals can be summed up in one phrase: All roads lead to inflation. If the government continues to fudge the statistics and run the printing presses, gold and silver will continue to rise in secular bull market fashion. Alternatively, if liquidity dries up and a deflationary spiral sets in, the Fed will eventually be forced to 'inflate or die,'

pulling out all the stops to avoid a Great Depression scenario.

The thesis regarding energy and infrastructure is a bit more complex, but still fairly simple. Between the ramifications of Peak Oil and the long-term implications of developing world growth, we are in the early stages of an energy bull market that could last another 515 years or more. Furthermore, we have barely begun to address the world's 21st-century infrastructure needs. There are many years' worth of work to be done.

So if one is mostly on the sidelines, better to jump in now or wait?

The problem with waiting is you don't know how far things will go before the big downdraft comes. It might be a long way off yet. And it might be smaller than you expect when it comes. No two ways about it, the ride is going to be wild at times. There will be setbacks, corrections and maybe even crashes between here and the ultimate goal. The best way to put cash to work? A little bit at a time. Don't plunge in all at once.

Investing for a crash: what kind of investor are you?

And keep in mind what is appropriate for an investor may not work for a trader, or vice versa. There is no clear line of demarcation between trading and investing, but at heart, they represent two distinct mentalities, with their own particular strengths and weaknesses.

The investor's key trait is patience, defined by some as 'the art of waiting without tiring of waiting.' This includes waiting out the pains of corrections, resisting the urge to cut and run when the chips are down. A good investor can handle a sharp setback, because he or she is focused on the ultimate goal. The investor's forte is holding on till the end of the move, be it months or years or decades in the making.

The trader's key trait, on the other hand, is flexibility. If you want to use tight stops and take profits on run-ups, that's excellent as long as you are willing to monitor things closely, make consistent decisions and re-establish positions at the appropriate time. The trader has more active responsibility than the investor, and willingly embraces that responsibility.

It is not a question of which mentality is better, but rather which mentality better suits you personally.

Investors are better off not trying to time the market, focusing more on the long term. The ideal is to have a solid base from lower prices on which you can build, but obviously, it takes time and patience to build that base. Many portfolio managers scale into their long-term holdings. Rather than loading up the boat at once, they will start with a half position, or even a third, a fifth or an eighth, and see how things go from there.

They also prefer buying into short-term weakness, if possible. The 50 EMA (50-day exponential moving average) is a popular place for scooping up stock. Barring that, breakouts to new recent highs can become self-fulfilling prophecies, as buyers step up for fear of getting left behind.

Investing for a crash: hedge your bets

For investors as well as traders, options can be an effective tool for mitigating short-to-intermediate-term downside risk.

Because options pack so much leverage into a small space, they are excellent hedging vehicles one of the things they were designed for. An outlay of, say, 13% of portfolio equity puts can help offset the downside risk of a much larger basket of equity positions. This can be an especially attractive thing when your stocks have run up sharply and you want to protect your short-term gains without selling out.

There are no easy fixes when it comes to portfolio mechanics, and no one can make the hard decisions of how much to buy and sell except you. That is why you rarely hear this stuff talked about in newsletters or the financial press.

As we progress, the energy and metals markets are likely to get even wilder, making a solid plan that much more critical. I encourage you to work out your mentality (trader versus investor, or somewhere in between), develop a clear plan for your positions and your overall portfolio and work from a thesis on every investment or trade you make.

In conclusion, if I had a large chunk of idle cash right now, I would be putting a portion of it to work, but not all of it. I would be monitoring useful tracking vehicles. And I would be looking to build a base over time not rushing in ahead of a potential market correction, but not staying passive on the sidelines, either.

By Justice Litle for The Daily Reckoning.

The editor of Outstanding Investments has worked with soybean farmers, cattle ranchers, energy consultants, currency traders, scrap metal dealers and everyone in between, including multiple hedge funds. Mr Litle also acted as head trader for a private equity partnership, and contributed to Trend Following, a popular trading book by Mike Covel (FT/Prentice Hall, 2004). You can read more from Justice and many others at www.dailyreckoning.co.uk.