Are You Ready for the Next Market Crash?

Having worked on Wall Street myself, I know that there are, in fact, some very fine folks smattered throughout. However, I also know that the people working on Wall Street have very specific jobs, and when it comes to equity strategists, most often that job is to make a case for stocks -- all the time.

That's why I got a good chuckle earlier this month when The Wall Street Journal ran an article that pitted the valuation work of Yale's Robert Shiller against Bank of America Merrill Lynch equity strategist David Bianco.

On the one hand, you've got Shiller, an academic whose work on the stock and housing markets revealed the massive dotcom and housing bubbles before they burst. His extensive dataset on stock-price history suggests that the market looks very pricey today.

On the other hand, you've got Bianco who, if I were to be unkind, I'd call a paid shill for Wall Street. He's suggesting that if you make a few "small" (they're really not small) tweaks to Shiller's work then suddenly stocks look cheap even after more than doubling from the recession bottom.

You may be able to tell who I side with. Of course, if the stock market is actually getting pricey, what should investors do to protect themselves?

Your best defense is a good defense
If you're worried about a pricey market, one of the first things that may pop into your mind is starting to play some stock market defense. But what exactly is a good defense?

For some perspective, I thought I'd turn back to the most recent stock market crash. If we say that the plummet began October 1 of 2007 and lasted until March 9 of 2009, then we're looking at a 56% loss for the S&P 500.

Now if you were to guess at which stocks shrugged off that free fall and held up well for investors during that raucous period, which direction might you point? Perhaps consumer staple stocks? Let's take a look.

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

Telecom is generally considered a "widows and orphans" category that tends to hold up well through tough times.

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

And of course we don't want to forget about utilities.

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

Looking at the tables above, a fan of relative returns investing would be stoked -- after all, the average returns of all three groups bested the S&P 500's loss during the period.

Now I don't know about you, but I don't know that I would have been ready to dance around and declare victory with a 30% loss (assuming I switched entirely to consumer staples). It would've been better than the average, but it's still one heck of a hit.

Defensive? Really?
So where were investors actually seeing gains during the market's meltdown? As we can see from the consumer staple table, Wal-Mart managed a small gain and it was joined by Family Dollar and Ross Stores as investors bet on consumers trading down to lower-priced retailers. Not all that surprisingly, gold miners also caught investors' eyes -- Eldorado Gold (NYSE: EGO) was up 68% and Harmony Gold notched a 47% advance.

But many of the best performers during the downturn were actually growth stocks that simply continued to charge ahead despite the rest of the market crumbling around them. Netflix (Nasdaq: NFLX) posted a very impressive 81% gain, while Ebix (Nasdaq: EBIX) tacked on 13% and Green Mountain Coffee Roasters rose 8%. At the outset of the crash, these stocks had price-to-earnings ratios of 24, 21, and 77, respectively, so it's not as if they were particularly cheap either.

Wrongheaded
When I start researching an article, I generally have an idea of what the data I'm collecting will look like. Sometimes, though, when the data is collected and sitting in front of me, it unquestionably obliterates my preconceptions.

In digging up this set of data I had expected to see that investors who fled to the so-called "defensive" stocks before the crash would have been spared the worst of the drubbing. To be sure, they could have claimed that they beat the market, but considering the losses they still sustained, that'd be like celebrating the fact that a carjacker didn't also take your shoes.

So what should investors do instead? Continue doing exactly what they're always supposed to do: Find stocks that offer attractive expected returns and own them until they no longer offer attractive expected returns. As those opportunities become tougher to come by, then it's time to start moving to the only truly reliable defensive position, which is cash.

While my one-period study here is hardly conclusive of anything, it seems like investors trying to jump around to play "offense" or "defense" may succeed primarily in racking up lots of trading fees. But now that I think of it, the "offensive" and "defensive" guidance usually comes from Wall Street -- a primary beneficiary of trading volume. Go figure.

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