How to survive the next market crash

How to survive the next market crash

Jerome Powell and the Federal Reserve may be in the process of driving the stock market over a cliff, bordering on a recession.

That’s a possible scenario envisioned by fund manager Mark Spitznagel, who actually thinks the Fed will blink with rate hikes soon. He’s not explicitly betting on either outcome, but he’ll likely find himself in the headlines again if the worst happens: The last time the U.S. economy contracted his firm, Universa Investments, earned a stunning 4,000 percent return. in a few weeks. Before that, during the financial crisis, it more than doubled clients’ money even as the stock’s value halved. Between those two drops, Universa made $1 billion in one day during the “flash crash.”

Individual investors would like to buy the kind of collision protection that Mr. Spitznagel, a protégé of “Black Swan” author Nassim Nicholas Taleb, sells to his sophisticated clients. But they can’t, and in their efforts to recreate it and gain some peace of mind, they end up hurting their returns. Techniques range from chronically misguided attempts to read the financial tea leaves and time the market to using products or investments advertised as hedgers.

For example, exchange-traded bonds that rise in value on down days for the market have become some of the most traded instruments on US stock markets since the start of the pandemic. ProShares UltraPro Short QQQ, which offers three times the daily inverse return of the tech-heavy Nasdaq 100, has shined, rising 32% over the past 12 months. But many of its fans don’t understand how awful it is to own for the long term, having lost 99.9% of its value since its inception in 2010. Getting the timing slightly wrong over the past year has also stung, with 45 days when the price of the note fell by 5% or more and seven days when it fell by at least 10%.

Even the classic 60/40 stock/bond portfolio, meant to smooth out returns in choppy markets, has disappointed this year as inflation soared, losing about 16% through Friday — almost as bad as holding a total stock index fund . Gold, a traditional hedge against inflation, has lost 9% this year and “digital gold” bitcoin fared much worse, down 57% through Friday.

Risk and reward are traditionally seen as a trade-off—a smoother return means you settle for a lower one. Mr. Spitznagel’s book “Safe Haven: Investing for Financial Storms,” ​​published a year ago, argues that it is not necessary. A leaked copy of his fund’s returns in the first decade to mid-2018, which predates his pandemic, does, too. A portfolio with 3.3% in Universa, which uses sophisticated derivatives to take advantage of extreme market movements, and the rest in an S&P 500 index fund, turned $10,000 into $31,900. One who just held the index rose to $25,307. Other portfolios with traditional hedges, such as gold and Treasuries, fared even worse.

In an interview last week, Mr. Spitznagel said that humans simply cannot reproduce this effect. His answer to the next best thing for individual investors is what Warren Buffett would recommend: Just buy and hold stocks for the long term.

A look at the markets shows that asset managers are moving money in ways that suggest they see a recession coming. WSJ’s Dion Rabouin explains what to look for and why we’re told investors are increasingly pricing in a downturn. Illustration by David Fang

This is surprising because Mr. Spitznagel is deeply pessimistic. While his mathematically driven fund constantly rolls over doomsday bets and doesn’t rely on short-term predictions, he sees the Fed backing itself into a corner with long-term consequences. The size of its balance sheet and the build-up of debt in the economy as a whole leave it with the option of continuing to try to crush inflation, thereby pushing the US into recession, or else abandon tightening as it did in December 2018 when it sent stocks back from edge of the bear market.

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Unless the Fed acts wildly out of character and continues to tighten, inflation will remain and bonds are no place to hide. A long-term bet on stocks, even if there is a crash in the near future, is the way to maximize wealth. Universa’s clients rely on its fund to feel comfortable staying invested in risky assets, willing to endure months or years of small, consistent losses on that small part of their overall portfolio. California’s massive public employee pension fund notoriously lost patience with Universa’s strategy shortly before the pandemic crash and 4,000% return.

Individual investors who can hold their nerve better than a board of bureaucrats have the best chance of weathering future financial storms. The strategy is simple, but certainly not easy.

Write to Spencer Jakab at Spencer.Jakab@wsj.com

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