How to Prepare for the Next Market Crash

When the stock market dropped to its lows during March, those courageous enough to buy had their pick of hundreds of stocks trading at bargain prices. Prices soared quickly, though -- so if you didn't jump in fast, you missed out on some amazing gains.

The losses that many stocks suffered during the worst market swoons in late 2008 and early 2009 were painful, true, but the bounces from those lows have been equally dramatic. Just look at the turnaround that many stocks have seen over the past six months:

Source: Capital IQ, a division of Standard and Poor's.

Obviously, if you were able to beat down all the impulses to run away from the market and instead bought at those lows, you're sitting on some pretty profits right now. The more important question for the rest of us, though, is whether it makes sense to get back into the market now, even after these huge run-ups.

Putting things in perspective
First and foremost, you need to consider how the rally plays into the bigger picture. It's true that the S&P 500 has bounced over 50% from its March lows. And while few people are arguing that the economic recession is already over, there are increasingly numerous signs that at the very least, things might be close to bottoming out. Historically, stock investors have done best by anticipating the economy's recovery rather than waiting for actual tangible proof to appear.

Yet the ever-present pessimists have plenty of points on their side:

• Even with this huge bounce, the S&P has only recovered enough to get back to last October's levels -- after much of the financial crisis had already begun.
• Despite signs of recovery, the economy is still fragile, and many danger signs still exist that could plunge it back into an extended recession.
• Many of the stocks that have bounced the furthest appear to be among the weakest. That's not necessarily the foundation you'd want to build a new bull market upon.

The biggest challenge, though, may well be figuring out how to get the financial system back to functioning in an orderly manner again. With dozens of federal programs propping up various industries and trillions of dollars being thrown at problem areas, any permanent solution has to deal with what will happen when those things are taken away. So far, the lasting results of these programs are far from clear.

In other words, if you think that the big stock market rally means you don't have anything to worry about, think again. Plenty of risks remain, and with stocks much higher than they were, the risks of buying stocks now loom even larger than they did in March.

Good news for those on the sidelines
But for those who missed out on buying at March's lows, all this bad news is really good news in disguise. With certain stocks having risen so high, you may no longer feel that they're good bargains. If a correction knocks 10% or 20% off their share prices, though, you may be ecstatic at getting a second chance to buy them at bargain levels.

The main question is whether you believe that the economy's long-term prospects are sound. If you do, then you necessarily must see any coming correction as temporary and a buying opportunity. As long as you can keep your wits about you when that correction actually comes, you'll be able to pull the trigger and buy shares this time around.

Get ready
The way to prepare for the next downward movement in the stock market, regardless of when or whether it comes, is to look at which stocks you want to target as potential opportunities. You may never see prices as low as they were in March, but by figuring out now how you'll handle whatever comes next for the markets, you can ensure that you won't stay on the sidelines forever.

Currency markets may hold the key to the next big downturn in the stock market. Tim Hanson explains why the dollar is doomed and what you can do about it.