Warren Buffett on Preparing for the Next Stock Market Crash

·3 min read

- By Robert Stephens, CFA

The stock market has experienced a stunning rate of growth since the March 2020 crash. It has gained over 80% and reached a record level in recent months.

However, history suggests that a market crash is certain to take place at some point in the future. After all, no bull market has ever lasted in perpetuity.

Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) chairman Warren Buffett (Trades, Portfolio) has a strong track record when it comes to capitalizing on market declines. Following his advice could be beneficial to value investors in the case of a stock market correction.

Market crash catalysts

Investor sentiment has improved dramatically over the past year. This is evidenced by the VIX Index's level, with a higher figure indicating greater fear levels among market participants. A year ago, it was 36. Today, it is just 18. This is the same level at which it stood prior to the Covid-19 pandemic.

The VIX Index suggests that investors are ignoring potential threats that could prompt a market crash. For example, the debt-to-GDP ratio has risen to over 100%. This suggests that higher taxes, or reduced government spending, may be required in the coming years to put the country's finances on a more stable footing.

Meanwhile, a dovish Federal Reserve could prompt a period of higher inflation. This may become an increasing cause for concern among investors, while risks such as rising corporate and personal taxes, trade wars and the ongoing pandemic could hold back the stock market's progress.

Predicting the next market crash

Of course, identifying potential threats does not make it any easier to predict when the next market downturn will occur. As the 2020 market crash showed, the stock market can be extremely unpredictable and lose significant portions of value over a short time period.

Furthermore, the wide range of factors that can prompt a market sell-off means it is impossible to accurately forecast how the stock market will perform in future. This means that timing the market is unlikely to be a viable option for investors who are currently concerned about the rich valuations on offer across multiple sectors and industries.

Indeed, this point has been highlighted by Warren Buffett (Trades, Portfolio). As he once said:

"The years ahead will occasionally deliver major market declines -- even panics -- that will affect virtually all stocks. No one can tell you when these traumas will occur."

A pragmatic approach

The average gain during a bull market has historically been 112%. This suggests that, should the current bull run follow the historic average, there may be limited upside available for many stocks.

Investors who are struggling to find buying opportunities in today's market may wish to hold some of their assets in cash. This will allow them to quickly react to a falling stock market in terms of buying high-quality companies at low prices.

Warren Buffett (Trades, Portfolio) has been known to hold cash for long periods of time in order to quickly capitalize on falling stock prices. Indeed, Berkshire Hathaway currently holds a record cash balance in excess of $140 billion (though investors should note that this figure is high largely due to the size of Berkshire's insurance business). As Buffett once stated, "The best chance to deploy capital is when things are going down."

Clearly, it may take several months, or even years, for stock prices to fall. However, investor sentiment appears to be relatively high given the breadth of risks present, while many stock valuations are currently at levels that are becoming difficult to justify.

Predicting the next crash may not be possible, but planning for its occurrence and being ready to take advantage of it by holding cash could be a productive strategy for value investors.

Disclosure: The author has no position in any stocks mentioned.

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This article first appeared on GuruFocus.