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Hedging Against a Big Market Collapse

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“So you love details and numbers,” my friend Christy asked me in a conversation last week.

“No. I love facts,” I replied. “I need facts to back up the assertions I make. I hate being in a position where I say ‘x’ and someone says that’s not right, and I have no proof to show that I’m right. So I go to great lengths to have those facts and to know my data is provably accurate.”

Thus, I can tell you without equivocation that the facts I have tell me a frightful story about the future direction of U.S. stocks.

We’re now at record levels on both the Dow Jones Industrial Average and the Standard & Poor’s 500 — records built atop unwarranted giddiness and held together by extreme optimism.

The problem, of course, is that giddiness and optimism are not Gorilla Glue. They are, at best, spit and bubble gum. Neither will last. A decline is imminent. The question is: How low can it go?

I have some ideas rooted in those facts I love…

When it comes to broad market valuations, I track what’s known as the Shiller P/E ratio — a measure of stock market valuation based on 10 years of inflation-adjusted earnings. To me, it’s a more accurate reflection of valuation, because instead of capturing a single moment in time (as does a traditional P/E ratio), the Shiller P/E captures the cyclicality that is inherent in earnings.

Today, the Shiller P/E approaches 27 — an oxygen-depleted level it has seen only three times previously: the 2004 to 2007 period when Greenspan’s low-interest-rate policy led to a housing and stock market bubble, the late ‘90s as the Internet bubble engendered a devastating euphoria and the giddy run-up to the Great Depression.

Revert that to the mean — about 16 — and the S&P tumbles sharply.

Bubble Investing

The Correction Will Cut Deep

Before I tell you how sharply, let me share another necessary fact: The bubble in corporate profits.

Corporate profit margins are near 10% these days — a level they’ve NEVER before seen. Typically, they range between 5% and 7%. Margins also happen to be one the most mean-reverting data points in the market economy. Blame that on capitalism.

High margins always attract competition, which, in turn, always brings margins back to norms.

If profits revert to the mean, and the Shiller P/E reverts to the mean, the S&P would be looking at a price below 1,300 — a 40% fall from current levels.

I get there by applying a historic sales growth rate of about 4.3% to the S&P’s sales of $1,100 per share for 2015 (giving me sales-per-share of about $1,147 for 2016); applying a 7% profit margin to those sales (giving me net income of about $80.31); and then applying a historically normal P/E ratio of 16 to those earnings (giving me an S&P value of 1,285).

Now, I’m not saying that’s the precise level we’ll hit. And I’m not saying S&P sales growth and profit margins will hit those levels this year, though they could.

I’m saying that these are the levels we will move toward because history has demonstrated forcefully that the market cannot sustain such rich levels indefinitely. It always — always — reverts to the mean.

Thus, it must correct. And that means much lower prices.

I won’t go into the same numeric breakdown, but I will tell you that the S&P also currently trades at price-to-book value of nearly three and a price-to-sales of almost two. (Those are not cyclically adjusted; they’re just a moment-in-time snapshot.) Both are double or more their historic norms.

Again, revert those to the mean, and the S&P 500 is somewhere between 1,130 and 1,320, roughly speaking.

Protect Against a Market Collapse

I’m not going to tell you the end of the good times are nigh without giving you some hope and a strategy.

First, the strategy. Go through your portfolio and axe the losing positions that you have no particular attachment to.

Then pare back some of your winners. If you’ve doubled your money in a particular stock, sell three-quarters of the position. You will recoup your original investment plus a 50% gain, and you can allow the remainder of the position to keep working for you.

There’s a good chance the remaining 25% you retain will fall in value in the decline that’s coming, but it won’t be as painful because you already locked in that 50% profit. Plus, the position isn’t likely to go to zero — so you will still be profitable — and when prices decline you can go back into the stock at a better value with all the cash you’ve built up.

Second, buy some put options, purely as you would an insurance policy on your house. Consider the cost of the puts the premium and deductible you pay to protect your home — only with this you’re protecting part of your wealth.

I’d be looking to own puts on the S&P out through next summer at the 1,800 level — the June 2017 180 puts on the SPDR S&P 500 ETF (SPY170616P00180000), to be exact. Those puts will cost you about $475 per contract based on prices as I write this Wednesday morning, which implies profits once the market gets to about the 1,750 level, a decline of 19% from where we sit today. That’s not out of the realm of probabilities.

Anything below 1,750 and you’re recouping some of the paper losses elsewhere in your portfolio.

I am not, by constitution, a pessimist. I am actually quite upbeat. But I am a realist — and I have my facts. And, realistically, those facts say that now is the time to avoid the optimistic giddiness that has pushed U.S. stocks to unsupportable highs. Now is the time to be a contrarian and prepare for the decline that’s in the offing.

Until next time, good trading…

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