Are You Ready for the 60% Stock Market Crash?

Could your portfolio withstand a 20% decline in stock prices? How about a 60% decline?

Perhaps you think the second question isn't even worth considering because the premise is so far-fetched. Nonetheless, one highly respected strategist thinks the S&P 500 will ultimately drop to 450 from its current level of 1,100 as this secular bear market reaches capitulation.

Allow me to introduce Albert Edwards
The man behind this gloomy prediction is Albert Edwards of French bank Societe Generale. In Thomson Reuters' 2009 survey of institutional investors, Edwards was ranked as the No. 2 Pan-European Economist/Strategist. The same investors also ranked Societe Generale's Global Strategy Team -- which Edwards heads up -- as the top Pan-European Sector Team.

Edwards is no consensus thinker, but neither is he a crank pandering to a fringe audience.

How do we get to 450?
All the same, 450 on the S&P 500 is the sort of figure one might normally associate with the ranting of a hardened gold bug. How did Edwards derive this figure? In fact, he simply looked at publicly available data on valuation lows associated with historical bear markets.

Edwards uses the cyclically adjusted price earnings (CAPE) multiple. One of the best long-term measures of value, the CAPE is calculated using average real earnings for the trailing 10-year period. Professor Robert Shiller of Yale has constructed a CAPE series for the S&P 500 stretching back to 1881, which is available on his website.

Will this time be different?
During the worst bear markets of the past century, the CAPE bottomed out in single digits (see table below). In fact, the CAPE has been known to spend months -- or even years -- there.

How about the current crisis? Based on Friday's closing price for the S&P 500, the CAPE currently stands at 19.2.

Even at the market low achieved on March 9, 2009, it was 11.9 – below its long-term average (16.3), certainly, but nowhere near the values that have historically accompanied capitulation in the stock market:

Month

Average CAPE

August 1982

6.64

December 1974

8.29

May 1942

8.51

June 1932

5.57

August 1920

5.02

Source: Robert Shiller.

Based on his review of the data, Edwards applies a rough multiple of 8 to the current trailing 10-year average real earnings of $54.44, and voila! Eight times $54.44 equals 436 for the S&P 500.

450 is no certainty
Now, I think it's worth being at least a little bit skeptical regarding this methodology. For one thing, although it may be all we have, our sample of bear markets is pretty small -- we're not talking about an established physical law here.

This is compounded by the fact that the S&P 500 dates back to 1957; the Composite index that preceded it had just 90 components.

Furthermore, before 1976, the S&P 500 contained no financial stocks! Even once this oversight was corrected, four-fifths of the stocks in the index were industrials -- it didn't contain a single company in the services sector.

Perhaps this time is different because the index itself is different; we're not comparing like for like.

Prudence is advisable
With that said, do I think investors should ignore Edwards' warning? Absolutely not! Although a 450 print on the S&P 500 looks unlikely to me, I have been saying for months that there is a very real chance we could revisit the March 2009 market low.

With the broad market overvalued, I suggest investors remain underweight stocks or stock index funds such as the SPDR S&P 500 ETF (NYSE: SPY  ) ; however, an underweighting alone isn't going to do the trick as far as protecting your portfolio during a major decline.

Gold as a hedge
One possible hedge is an overweight position in gold via the SPDR Gold Shares (NYSE: GLD  ) . While gold isn't an explicit hedge against stock declines, the catalyst that will usher in the next bear phase in stocks will very likely be a positive catalyst for gold (it could be another flare-up in the ongoing sovereign debt crisis, for example).

Better than gold
A more effective way to hedge your portfolio against a looming correction is to dedicate a portion of your portfolio to "short" positions, focusing on stocks that are the most highly vulnerable in a correction. That could include stocks that have experienced the greatest run-up in prices and exhibiting "premium" valuations.

The stocks in the following table fall into both of those categories:

Company

Year-to-Date Return

Forward Price-to-Earnings Multiple

Las Vegas Sands (NYSE: LVS  )

112%

33.2

Huntington Bancshares (Nasdaq: HBAN  )

59%

16.8

Titanium Metals (NYSE: TIE  )

49%

37.4

VMware (NYSE: VMW  )

100%

55.9

Atmel (Nasdaq: ATML  )

44%

15.2

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

Let me be very clear that these stocks aren't short recommendations. It would take more than a two-criteria screen to achieve that. Shorts are good hedges, but smart investors seek out those that will be profitable whether or not a market correction actually occurs.

If all you want is a pure hedge, you could simply short an index ETF; meanwhile, finding shorts that will be profitable in an up or down market takes expertise and effort.

Profitable investing in a bear market: The next step
If you'd like to earn positive returns in a bear market and reduce the volatility of your portfolio, I think you'll be interested in John del Vecchio's free report "5 Red Flags – How to Find the BIG Short." Most recently, as the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points.

To find out more about how he achieved those returns and take the next step toward putting a proven methodology to work in your portfolio, enter your email address in the box below.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. VMware is a Motley Fool Rule Breakers recommendation. Titanium Metals is a Motley Fool Stock Advisor selection. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The  Fool has a disclosure policy.


Read/Post Comments (12) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 10, 2010, at 3:15 PM, Mstinterestinman wrote:

    54 dollars might be the ten year average but this is including a couple major busts. S@p 500 Earnings are around 80 dollars right now when you take that into consideration at the low we were in fact a forward mutiple of single digits. Stocks are a lot cheaper than many want to admit but if you want to wait for the robins I will happily enjoy spring wthout you ;)

  • Report this Comment On September 11, 2010, at 2:23 AM, joandrose wrote:

    Sorry - but I find purveyors of gloom and doom a pain in the butt. The minute a bit of sunshine emerges there is always some idiot with a new pet theory to prove that we are all going down the tubes. The danger is that if enough of an audience believes this statistical mumbo jumbo - it can become a self fulfilling prophecy !

  • Report this Comment On September 12, 2010, at 12:00 PM, henryking54 wrote:

    I checked the CFA Institute website and Mr. Dumortier is not listed as a being a CFA charterholder. Be careful of people who claim to be a CFA charterholder who aren't.

  • Report this Comment On September 12, 2010, at 7:24 PM, ChrisBern wrote:

    For those who think stocks are underpriced, CAPE at 19.3 is not cheap by historical measures, period--it's about 20% higher than the average CAPE, and surely the average CAPE measurement had better economic prospects than today!

  • Report this Comment On September 13, 2010, at 10:06 AM, spokanimal wrote:

    I've read 2 pieces so far today: This one, and Don Hay's latest report. On a scale of 1 to 10, this one gets a 1 and Don got a 10.

    My kid's cartoon got a 2.

    AMAZING that someone would indicate those stocks are vulnerable based on the (lack of) rationale portrayed in the first part of this article...

    AMAZING.

    S.

  • Report this Comment On September 13, 2010, at 10:10 AM, NOTvuffett wrote:

    The sky is falling, lol.

  • Report this Comment On September 13, 2010, at 11:46 AM, ChrisFs wrote:

    Dedicating a part of one's portfolio to GLD and shorts in case of a possible huge drop used to be the hallmark of kind of small 'f' foolishness that Motley Fool warned against. Now it's a top story.

    Shorting is a shorter term strategy and shorter term strategies require more selling and buying, thus more commissions out of your pocket.

    What is your time horizon? if it's short, sell, if it's longer hold on and maybe buy more. That's the Foolish way.

  • Report this Comment On September 13, 2010, at 12:39 PM, stan8331 wrote:

    Shorting an array stocks based on the expectation that they will do most poorly if we have another huge market crash seems like an incredibly dangerous strategy to me. Options would be a far safer way to hedge risk for individual investors, but all that's really necessary is to ensure one holds enough cash or other highly liquid assets to take advantage if a major new buying opportunity were to emerge.

    I would also point out that back in March 2009, many of the folks now predicting a second crash were telling anyone who would listen that they would have to be insane to go long on stocks. Anyone who went out and put all their money in shorts based on that advice probably has no money left to purchase more shorts now.

  • Report this Comment On September 13, 2010, at 2:16 PM, TwentyTwoHands wrote:

    Too big to fail? Not for these major brands that may simply disappear before the end of 2011. Who are these corporations, and why have they failed after weathering the economic storm of 2008?

    Economically we are seeing many corporations failing, without any chance of the major bailouts lesser brands took in the past. Some are in publishing, others are a major oil company, and a bailed out financial institution after the previous market crash.

    Who are these corporations, and why have they failed after weathering the economic storm of 2008?

    1. British Petroleum (BP)

    A leader in global oil production which should be expanding as our world faces dwindling oil resources. Yet the day oil started spilling from the Deepwater horizon exploration rig, in the south of the United states- it spelled the end of the new horizon for BP. Failing to stop the spill- BP in the states faces billions of dollars of lawsuits, and may have to be broken up globally.

    2. Merrill Lynch

    Bailed out and now owned by the Bank of America aka the American people. Merrill Lynch was one of the United States biggest brokerage firms. It also was a company that many in the US government started their career in- including the current Federal Reserve Chairman.

    The company has recently been hit by allegations of corruption and financial scandals, which most likely will not attract any future buyers with it's tainted reputation. Merrill Lynch's future lays in being asset stripped, dissolved and sold off in parts, but the name could vanish forever.

    3. T Mobile

    T mobile dominates the uncompetitive mobile phone market in Germany, and is owned by Deutsche Telekom. In the states T-Mobile is a bit player in a more open and competitive market. A declining market share, may lead to T-Mobile being closed in the states, but in the more controlled German market, it may still thrive until the market truly opens up.

    4. Readers Digest

    Popular around the world, and translated in over 60 languages worldwide, Readers Digest in the United States just emerged from insolvency this year. Whilst the American edition is running at huge losses, overseas editions are still making a profit. We could see Readers Digest disappear forever from the US, but remain as a "localized" magazine overseas, maintaining the brand name.

    5. Blockbuster

    Online movies and DVD's by order killed the video star, which failed to adjust to a new online age. Since 2008, Blockbuster stores have seen continued decreases in their market share, and many have already closed shop. What was once a market leader in the new age of video, now looks to be finally buried in the golden age of the internet.

    6. Moodys Corp

    Once everyone looked to Moody's to see what ratings it gave Governments and Corporations. The company was trusted globally, until after 2008 reports grew about how the ratings agency compromised its ratings to secure business. A bond of trust was broken, as were billions of dollars of investments lost -based on Moody's ratings. As this former giant faces legal actions, and the wrath of suspicious governments- it is doomed to close.

    7. Kia Motors

    The recession has badly hurt the automobile industry, and Kia could be the next brand to be ditched by its owner Hyundai. A marginal brand that produced smaller cars, faces too much competition, and a declining market. Hyundai are looking to consolidate its business, and Kia is the obvious target for closure.

    Many of these businesses were once proud market leaders, but eventually failed because of declining markets, a failure to adjust to new competition, and in some cases because of financial incompetence. In 2011, the message is clear, unlike 2008- no company is too big to fail.

    ----------------------------------

    Money without intelligence is like a car without a road.

    http://www.intelligentinvestingtips.com

  • Report this Comment On September 13, 2010, at 4:37 PM, TMFAleph1 wrote:

    @spokanimal,

    I don't follow you -- can you be a little bit more specific in your criticism, please?

    Alex D

  • Report this Comment On September 13, 2010, at 5:25 PM, henryking54 wrote:

    VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE

    B. Reference to CFA Institute, the CFA Designation, and the CFA Program.

    CFA Institute membership

    Requirements to be granted the right to use the CFA or Chartered Financial Analyst designation:

    1. Passed all three levels of the CFA program;

    2. Received the charters;

    3. Makes an ongoing commitment to abide by the requirements of CFA Institute's Professional Conduct Program (including filing an annual professional conduct statement);

    4. Due-paying (every year) charterholders in good standing.

    If a member fails to meet either 3 or 4, he or she cannot claim him or herself as a member.

    All CFA Institute members and CFA candidates must abide by the Code and Standards. Violations may result in disciplinary sanctions by CFA Institute. Sanctions can include revocation of membership, candidacy in the CFA Program, and the right to use the CFA designation.

  • Report this Comment On September 24, 2010, at 3:40 PM, FutureMonkey wrote:

    Just because current CAPE is 19 and typical low CAPE at bottom of long secular bear cycles is 8, does not mean the SP500 is likely to bottom to 450. It certainly does indicate that the market is still overvalued at todays earnings relative to long bear cycle trends (i.e. we don't just go down to average CAPE of 16 before the next Bull cycle, we always swing down to well undervalue). But that doesn't mean 60% drop tomorrow. Most Bears the price wiggle sideways for many years until earnings rise to the low CAPE then earnings and price to earnings.

    So, we might expect that we find some point in the next couple of years that has an equivalent to 450 relative to todays earnings, but since earnings will be higher. the ratio is lower. For example, if earnings gain 125% over the next 8 years, but SP500 rattles around anemically between 1000 and 1400 and at sometime in 2018 bottoms at 1150, that could give us the "bottom" that is typical of the worse point in a bear market before the bull cycle returns.

    On the other hand maybe the CAPE of 11.9 in March 2009 was the low point of the current bear cycle....hmm.

    FM

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