As this year comes to an end we will see all sorts of predictions about what kind of future 2009 holds in the market. While predictions make for interesting reading, they are often wrong.
I believe it is more constructive to seek out risks that lie ahead and construct a game plan in the event those risks play out. The goal with this exercise is not to be right but to be prepared ahead of time for the unexpected. This type of preparation means you won't have to react on the fly in an emotional state as events play out.
First, a History Lesson
The roughly 40% decline in the S&P 500 qualifies 2008 as one of the worst years on record. The decline was rapid, causing a great deal of investor pain. After such a huge fall-off there could be more risk from here to the upside.
The market has of course had fast, painful declines in the past, and often they have been followed by massive rallies. Consider this: In 1935, the Dow Jones Industrial Average soared 40% followed by a 27% rise in 1936. This massive two-year rally came on the heels of the worst economic period in our country's history. How many people do you suppose saw that one coming?While I don't have access to sentiment data from the 1930s, it is a reasonable assumption that going into 1935 sentiment was at least as bad as it is now. At 104.04 on Dec. 31, 1934, the Dow was down 73% from its 1929 high; yet, the rally of 1935 and 1936 happened anyway. It was not a new bull market, more like a massive bear market rally.
2009 Rally: Leaders, Velocity Are Key
What is the best thing to do if there is a huge rally that catches people by surprise? People are afraid of a big decline in the market. A big move down certainly could happen from here of course, but the way the market tends to work, the risk of a big decline is much less after we've already experience a big fall-off. People are very afraid these days, and usually big declines are a byproduct of not enough fear.