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In the aftermath of the financial crisis, stocks have seemed like they could go up forever. But instead of falling back into the trap of being complacent about your investments, take this opportunity to make sure that your portfolio won't take the same hit it did last year if the secular bear market comes back.
Lately, we've seen a reversal in the way people are thinking about the economy. Rather than focusing on every single piece of negative news -- and there's still plenty of it -- investors appear to be looking toward a brighter future. As prospects improve, even beaten-down financials like Citigroup (NYSE: C ) and Fifth Third Bancorp (Nasdaq: FITB ) have seen strings of money-losing quarters come to an end. Stocks once left for dead have posted huge gains.
The resulting optimism has allowed the recent market rally to continue beyond most people's wildest expectations. Yet yesterday's big pullback in stocks shows just how vulnerable the recovery is. Soon, investors won't be satisfied with the prospect of future prosperity -- they'll want to see concrete signs of a recovery now, and if they don't see those signs, then look out below.
One other reason investors are getting skittish is that some of the favorable conditions supporting stock prices may start going away soon. For instance, the low interest rates we've seen throughout the financial crisis have given investors a big disincentive to keep money in low-risk assets like cash and bonds.
Yet Federal Reserve governor Kevin Warsh said last week that the Fed might need to raise rates sooner and faster than it has following previous recessions. Although few believe that Fed rate increases will come anytime soon, the statement reminded investors that inflation remains a long-term threat that the Fed will have to address sooner or later.
The next step for right now
Regardless of whether yesterday's decline was just another in a long series of small pullbacks or the beginning of a long-awaited correction, there are several things you should do now to make sure you're ready for whatever the future brings.
1. Get your risk right.
Most investors seek to control risk while maximizing returns by spreading their money across different asset classes. The idea is that when one group of investments loses money, the others gain or hold their value, so that overall, your portfolio is much less vulnerable to losses than it would be if all your money were in just a single investment.
After a big stock market move, though, you may have a riskier portfolio than you did back in March. With the S&P having risen as much as 50% from its lows, a 50/50 asset allocation between stocks and bonds back in March could be up to 60% in stocks right now. Moreover, if your portfolio includes stocks like American Express (NYSE: AXP ) , Wynn Resorts (Nasdaq: WYNN ) , and Teck Resources (NYSE: TCK ) , which have seen colossal returns from their lows, then it might be even further out of whack.
Now's a good time to look at your investments and see if they match up with your target allocations. If not, then rebalancing could prevent a surprise like the one many investors got during last year's stock market plunge.
2. Watch your dividend stocks.
Dividend stocks can be a great way to protect your portfolio from downturns. But instead of just taking a stock's dividend at face value, look deeper to see if changing economic conditions could jeopardize it.
For instance, some dividend payers, including Boeing (NYSE: BA ) and Windstream (NYSE: WIN ) , carry substantial debt on their balance sheets. During the economic downturn, low interest rates made it easier for companies to cover that debt. However, if a company has to refinance at higher rates, then the business has to become more profitable in order to support its debt.
Right now, Boeing has a low payout ratio, which indicates it has the means to cover dividend payments in addition to the possibility of rising debt payments. Windstream, though, has a higher dividend yield and a payout ratio above 100%, showing that it has less flexibility. Although it's not a sign of an imminent dividend cut by itself, high debt can push a company to the breaking point -- especially if the economy fails to behave.
Stocks won't go up forever, but you can still take steps to protect your investments. By actively managing your investments, you can take action to reduce risk before the next big downturn hits.
Fool John Rosevear has been expecting a downturn, and it looks like he may be getting one. Learn what he's telling people to do to be ready for another crash.