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:

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:

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.