How to Prepare for the Inevitable Stock Market Recovery

Don’t let it catch you by surprise

Most investors have had an unpleasant 2022, and with dark clouds forming on the horizon, 2023 doesn’t look any better. Consumers face rising inflation that interest rate hikes haven’t stamped out. If history is an indicator, we need a double-digit interest rate to get rid of inflation. The Fed raised interest rates to 20% in 1980 to stave double-digit inflation in that era.

The layoffs are also accumulating. Most big tech companies are freezing hires and planning layoffs. As more people get laid off, economic activity will decline and lead to further losses. Interest rates will rise at a slower pace moving forward, but each hike will hurt the economy in the short term.

With the economy and stock market reeling and headwinds remaining persistent, it’s easy to ignore the stock market for a year or give up on it entirely. Patient investors swoop in during uncertainty to buy shares and let time do its magic.

Buying stocks now can feel like flushing money down the toilet, but we will eventually have a stock market recovery. Paying attention to important metrics and knowing where to put your money can help you reap higher returns. Here’s how to prepare for the inevitable stock market recovery.

Pay Attention to Inflation and Interest Rates

The Federal Reserve’s policies create tremendous market fluctuations. Index funds have experienced intraday 2%+ swings during Federal Reserve meetings and new inflation data. High inflation leads to demand destruction and forces the Fed to continue raising interest rates. As inflation cools, the Fed will pause rate hikes and even lower their rates. This development would be great news for the stock market and investors.

Inflation will show signs of cooling off before the Fed considers lowering interest rates. A single month of reduced inflation isn’t enough of a gauge. Consecutive months of declining inflation can create the setup for a pause on interest rate hikes or even reduced rates. The Fed hopes to begin lowering interest rates in 2024.

Some Companies Are Still Growing

2021 created unsustainable stock valuations and brought many speculators into the space. 2022 presented the opposite dynamic, with many growth stocks plunging more than 80% from their all-time highs.

Even large-cap stocks have declined, with Facebook leading the way. In perhaps the biggest shock, Facebook’s parent company Meta has lost over 70% of its value over the past year.

Negative year-over-year growth in earnings and revenue has hampered the company’s growth prospects and valuation. Facebook’s P/E ratio sits below 10, which would have been a steal a few years ago. Facebook’s current business model has holes, and like many others, leadership is using layoffs to protect the bottom line.

Despite challenging market conditions, some companies have achieved year-over-year growth in earnings and revenue. Just like Facebook, Qualcomm also has a P/E ratio under 10. The company has an inventory glut, but strong year-over-year revenue and earnings growth indicate the company’s resilience during this challenging cycle. Double-digit revenue and earnings growth didn’t stop the company from tumbling almost 40% year-to-date. The company also offers a 2.67% dividend yield and raised the dividend by 10.3% this year.

Most of the companies that perform well during economic uncertainty will perform well during the next bull market.

Micro Caps Will Lead the Way

It doesn’t take as many investors to move micro cap prices due to their lower market caps. These stocks were among the first to fall in 2022, while it took longer to see declines in large cap companies. Once investors become bullish again, micro cap stocks have strong potential for outperformance. A Prudential document produced during the Great Recession recommended micro cap stocks as valuable assets to increase returns during an economic recovery. Here’s a snippet from the document:

“Since smaller companies tend to be more nimble and often react faster to changes in the business environment than larger companies, they may bounce back more quickly and grow more rapidly in a recovery. In fact, small caps have significantly outperformed large-company stocks in the first year following 9 out of the last 9 recessions.”

The 2020 Stock Market Flash Crash reinforced this phenomenon. Micro cap stocks led the recovery and comfortably outperformed large cap assets. This trend fell apart in 2022 because that ‘recovery’ meant creating a larger bubble. True to the micro cap trend, stocks with smaller market caps got hit the hardest and earlier than large caps. The report from Prudential suggests small caps will have a stronger recovery than large cap stocks once we make the transition.

Establish An Emergency Fund

Investors have experienced substantial volatility in their assets this year. Emergency funds provide a haven in volatile environments and act as financial safety nets. A cost of living crisis and declining asset prices make now a good time to build up your emergency fund.

Having more cash reserves makes it easier to navigate a rocky portfolio and have a backup for higher prices or getting laid off. Investors can’t control rising prices, but they have more control over their careers and building up their emergency funds.

Set Portfolio Goals

Goals keep us motivated and remind us to stay focused on building long-term wealth. Establishing ambitious year-end portfolio goals will inspire action and help you capitalize on the stock market recovery. Many investors passively invest a set amount of money each week or month, depending on their preferred interval.

You can also list your favorite stocks and identify how many shares you want by the end of the year. If you currently have 100 shares of XYZ stock and want to own 300 shares by the end of 2023, you’ll have to accumulate 200 shares. You can purchase some shares each month or wait for the price to fall further.

Investors can use this approach for each stock they want to accumulate in 2023 and plan for the next three years. You can make adjustments if one of the companies has structural changes, but it’s better to set ambitious goals. A bigger target inspires more action, and short-term stock price declines can work in your favor. Organizing this information in a spreadsheet makes it easier to browse through the data, and some spreadsheets provide real-time stock prices. Spreadsheets with this feature let you see how much capital you need to achieve your share quantity goals.

The Stock Market Does Not Crash Forever

Investors would generate stronger returns if they used logic instead of emotions. Unfortunately, many of us make investments based on impulses. A few red days rattle many long-term investors, and this current market has been tough for many people.

At some point, the stock market will recover. Stock prices will demonstrate meaningful and sustainable growth. Knowing what to look for and planning accordingly can help you capitalize on a recovery instead of missing out.