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Prepare to Profit From the Next Stock Market Crash

Stock-Markets / Financial Crash Sep 27, 2011 - 07:14 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleMartin Hutchinson writes: The notion of a stock market crash is a terrifying thought for most investors.

But it shouldn't be. After all, stock market crashes, properly played, can be just as profitable - if not more so - than bull-runs.


Of course, the trick to profiting from stock market crashes is predicting them.

That's where I can help. You see, a relatively simple analysis shows that the Dow Jones Industrial Average has gotten ahead of itself. More than that, it's giving a pretty clear signal about where the blue-chip benchmark is headed.

Let me explain ...

A Market Mismatch
Despite any recent losses the stock market is still extremely high by historical standards.

Remember, it wasn't so long ago - February 1995 - that the Dow first passed 4,000. That was thought to be a pretty high level at the time, as it was almost 50% higher than the 1987 peak.

The Dow closed yesterday (Monday) at 11,043.56, which is inconsistent with economic growth prospects.

That is, nominal gross domestic product (GDP) in the second quarter of 2011 was up 105% from the first quarter of 1995. So if you assume that the stock market over time should follow national output, then a middling level for the Dow today would be about 8,200 - more than 2,500 points below the present level.

And keep in mind that that's a middling level - not a bear market.

If you want an idea of how far the Dow might slump in a bear market, you can take the 777 at which the index stood in August 1982 - before the great bull market began - and inflate it by the progress of GDP since then. If you do that, you get a bear- market target of about 3,600 for the Dow.

Incidentally, a few years ago I met Kevin Hassett, the AEI scholar, who along with James Glassman wrote a book in 1999 called "Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market." He's a very nice guy. I made a bet with him that the Dow will reach 3,600 before it gets to 36,000. He's teased me about it since saying I lost my chance, but it looks as though I may get him yet.

A Matter of Motivation
The stock market may be significantly higher than it was in 1995, but I assure you our economy is no better off.

In 1995, we were just at the beginning of the great Internet boom. The federal budget was moving towards balance, helped by a wind-down of military spending after the collapse of communism. And the Federal Funds rate was at 6% -- safely above the inflation rate of 2.9%.

From this investment perspective, things couldn't have gotten much better.

But look at where we are now. Our technology "boom" consists of a few flimsy social networking websites. The federal budget deficit was $134 billion in August pushing the shortfall for the fiscal year to date to $1.23 trillion. And the Federal Funds rate has been at a record-low range of 0.00% to 0.25% for almost three full years, while inflation edges steadily higher.

Indeed, it's not the economy that has driven the stock market higher. Instead, it's been three other factors:

•First, ultra-low interest rates together with increased leverage have inflated corporate profits.
•Second, modern communications technology has enabled multinationals to profit from low-cost global sourcing.
•And third, money -supply expansion - with the St. Louis Fed's broad money MZM up 262% since 1995 compared to GDP's 105% increase has inflated all asset prices. Most notably housing prices in the middle 2000s, Treasuries and gold today.

How to Profit From the Stock Market Crash
That's where we've been - here's where we're going.

Interest rates must eventually rise to prevent inflation and the de-capitalization of the United States through low savings and capital outflow. This will raise the cost of capital compared to labor, putting millions back to work, so it doesn't necessarily mean we'll see a double-dip recession as a result.

Capital returning to the United States will slow growth in emerging markets. It will also put an end to the multinationals' outsourcing bonanza. You can already see pressure on profits in the financial sector, and that pressure will soon spread to the entire economy.

A stock market crash will accompany this process, but a major U.S. recession won't. The Dow will almost certainly test the middling valuation of 8,200 and there's even a chance that it will slide towards 3,600.

But again, that will only snuff out the weaklings, leaving us with stronger investment prospects and a healthier overall economy.

Winston Churchill in 1925 said that he wanted to see "finance less proud and industry more content." In 2012-13, he may get his wish - and for those who suddenly have new job opportunities, it will seem not a moment too soon.

Actions to Take: For investors, the advice is clear.

Emerging markets remain a better bet than U.S. stocks, since their markets in general are less overvalued. However, to take advantage of the likely U.S. stock downturn, the best bet is out of the money S&P 500 put options, traded on the Chicago Board Options Exchange (CBOE).

Buy the longest- dated contract possible, to give the downturn time to play out. For example, the December 2013 600 contracts (CBOE: SPX1321X600E) currently are trading around $40. If the full bear market scenario were to play out by December 2013, the Standard & Poor's 500 Index would presumably trade around 400, giving at least a fivefold profit on these options.

Don't put more than 4% to 5% of your portfolio in this: Being an option, its value decays with time, but as a hedge to your overall stock position it's unbeatable.
[Editor's Note: Back in mid-August, Martin Hutchinson timed a stock recommendation so investors could lock in a 13% yield.

Two weeks ago, he uncovered a stock with a dividend payout of better than 14%.
Then on Sept. 13, he told investors about one stock that featured a 10% payout, and a fund that was about to make two payouts - a dividend payment and a capital-gains distribution.

If you're a subscriber to Hutchinson's Permanent Wealth Investor advisory service, that's the kind of performance you can expect. Find out more by clicking here.]

Source : http://moneymorning.com/2011/09/27/prepare-to-profit-from-the-next-stock-market-crash/

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