How to survive the next market crash?

How to survive the next market crash?

Jerome Powell and the Federal Reserve may be pushing the stock market over a cliff by tightening into a recession.

That’s one of the possible scenarios envisioned by fund manager Mark Spitznagel, who actually thinks the Fed will blink with rate hikes soon. He doesn’t explicitly bet on either outcome, but would likely make headlines again if the worst comes out: The last time there was a contraction in the U.S. economy, his company, Universa Investments, achieved a stunning return of 4,000% in a matter of weeks. The time before that, during the financial crisis, he more than doubled customer money, even as the value of stocks was halved. Between those two recessions, Universa made $1 billion in one day during the “flash crash.”

Individual investors would like to buy the kind of crash 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 peace of mind, they end up hurting their returns. Techniques range from chronically misguided attempts to read the economic tea leaves and time the market to using products or investments advertised as hedges.

For example, exchange-traded bonds that appreciate on days when the market appreciates have been among the most traded instruments on U.S. exchanges since the start of the pandemic. The ProShares UltraPro Short QQQ, which provides three times the daily inverse return of the tech-heavy Nasdaq 100 Index, has outperformed and is up 32% in the past 12 months. But many of his fans don’t understand how awful it is to own in the long run as they have lost 99.9% of its value since the beginning of 2010. Slightly mistaking the timing of the past year has also hurt, with 45 days when the price of the note fell 5% or more and seven days when it fell by at least 10%.

Even the classic 60/40 stock/bond portfolio, designed to smooth out returns in volatile markets, has been disappointed by rising inflation this year, losing about 16% through Friday – almost as much as owning a total index fund in the stock market. Gold, a traditional inflation hedge, has lost 9% this year, and bitcoin for “digital gold” has fared much worse, falling 57% through Friday.

Risk and reward are traditionally seen as a trade-off: a smoother return means settling for a lower return. Mr. Spitznagel’s book, “Safe Haven: Investing for Financial Storms,” ​​published a year ago, argues that this need not be the case. So does a leaked copy of its fund’s first decade to mid-2018 returns, which predate the pandemic bonanza. A 3.3% portfolio in Universa, which uses advanced 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 that just owned the index grew to $25,307. Other portfolios of traditional hedges such as gold and government bonds underperformed.

In an interview last week, Mr. Spitznagel said that individuals simply cannot replicate that result. His answer to second best for individual investors is what Warren Buffett would recommend: just buy stocks and hold them for the long haul.

A look at the markets shows that asset managers are moving money in a way that suggests they see a recession coming. WSJ’s Dion Rabouin explains what to look for and why they tell us investors are increasingly anticipating a recession. Illustration: David Fang

This is surprising, because Mr. Spitznagel is essentially a pessimist. While his math-driven fund is constantly running doom scenarios and not relying on short-term forecasts, he sees the Fed being cornered with long-term ramifications. The size of his balance sheet and the build-up of debt in the economy generally leaves him with the choice to continue trying to crush inflation, driving the US into a downturn, or else give up on tightening, as in December 2018 when the country bounced stock from the brink of a bear market.

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Unless the Fed acts wildly out of character and continues to tighten, inflation will hang and bonds will have no place to hide. A long-term bet on stocks, even if a crash occurs 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, steady losses on that small portion of their overall portfolio. California’s huge public employee pension fund infamously lost patience with Universa’s strategy shortly before the pandemic crash and that 4,000% return.

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

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

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Appeared in the print edition September 20, 2022.

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