Beware! Markets look vulnerable – here’s how to protect yourself

published 27 August 2013

13-8-27-NYSE-trader — Could stock prices fall by 50%?

There's a pretty scary piece by respected US fund manager John Hussman doing the rounds at the moment.

Hussman has been bearish all the way through the post-2009 rally, which has dented his reputation somewhat. But I specifically remember citing a crash warning' from him in a MoneyWeek article warning of the pending credit crunch in the summer of 2007, and he called that top rather well. So I'm certainly not inclined to dismiss the man.

And right now, his various indicators suggest the US stock market could fall by 40-50%.

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How likely is such a fall? And what can you do to shield against it?

The stock market looks very vulnerable

John Hussman's crash indicators aren't perfect by any means no indicator is.

But apart from a few false alarms in 2012, says Hussman, "the last time we observed return/risk estimates similar to the present was the week of July 27, 2007". Before that, it was September 2000. And before that, August 1987 (right before the October crash).

That track record strikes me as worth paying attention to.

I'll not go into all the indicators in detail. Some are technical (ie, based on chart analysis). He looks at how overbought' the market is, for example. But he also considers sentiment: when most investors are bullish, that's a bad sign. And he also looks at valuation. Using the cyclically adjusted price/earnings ratio (the Cape, or Shiller p/e), the S&P 500 is over-valued compared to its historical average, and has been for a long time.

The point is, they're all indicating that stocks are primed for a big fall. The only thing preventing them, reckons Hussman, is faith that central banks are in a position to save us all. But as John Mauldin puts it, "faith in central banks today is equivalent to faith in the word dot.com in 1999, or faith in the eternal rise of housing prices in 2006."

It wouldn't take much for that faith to be shattered. And the sticky process of withdrawing from quantitative easing could be just the pin needed to pop investors' bubble. Or maybe the German election doesn't go as planned next month. Or maybe the US (and by extension, the rest of us) gets itself entrenched in yet another intractable saga in the Middle East, via Syria this time.

But what on earth can you do about this?

Of course, it's all very well to say that markets look poised for a crash. But what can you do about it? Selling everything you own and going into cash is a drastic move, particularly if the crash you're hoping for doesn't materialise.

However, this isn't all about swapping one risk (the risk of a stock market crash) for another (the risk that you have all your money in cash, and the market does nothing but rise). It's a reminder to make sure that you're comfortable with the way your portfolio is positioned right now.

Hussman himself isn't saying, "Quick! Get out of the market now!" Instead, he's saying, review your portfolio, and look at what you hold. If you wouldn't be happy holding on to it during a period where the market falls hard, then it might be time to sell.

But how do you decide on what you'd be happy to hang on to? Here's a quick and simple way to do it. Look at each of your holdings individual stocks, whole markets, investment trusts, whatever - and remind yourself of why you bought it.

Did you buy because it's good value? And if it got even cheaper, would you relish the opportunity to buy more? If you can honestly say yes', then hang on.

For example, I'm not too worried about my investments in Italy right now. It will take a hit if sentiment sours over in the US, no doubt about it. The US is such a dominant market that if it falls, the rest will fall too. That's just the way it works.

But unlike the US, which is historically overvalued, Italy is already cheap. If it falls further, it just gets cheaper. In the long run, which is what I'm holding out for, it's likely to become more expensive than it is today. And that's when I'll aim to sell.

What about your more speculative punts? If you bought a stock (or a market) on a wing and a prayer, in the hope it would keep rising, now's probably a good time to take profits.

If you're not sure of which category a holding falls into, then imagine how you'd feel if the price fell by 25% from where it is today. If you would be excited by the buying opportunity, hang on to it.

If you'd feel a painful stab of regret at not cashing in, then sell it. And for the time being, you could hold on to the cash in the hope of being able to put it to work at a later date, if and when prices do indeed topple.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.