The increasing likelihood of a black swan event that causes a drastic market downturn should prompt investors to consider three key strategies to protect against major losses, according to Shalin Madan, the founder and chief investment officer of quantitative firm Bodhi Tree Asset Management. "The current environmental conditions are ripe for a Black Swan," he says, adding, "We think that it's an extremely dangerous period right now."

To prepare for catastrophic market losses, Madan offers three strategies that Business Insider matched with three exchange-traded funds (ETFs). The first strategy calls for investing in long-duration U.S. fixed income debt, which investors can execute by buying shares of the iShares 20+ Year Treasury Bond ETF (TLT). The second strategy is buying gold, which can be executed at less risk by purchasing the SPDR Gold Shares (GLD). And the third one calls for taking positions in real estate investment trusts, easily available through the SPDR Dow Jones REIT ETF (RWR).

Key Takeaways

  • CFO of Bodhi Tree Asset Management sees risk of black swan event.
  • Investors should position for high likelihood of bear market.
  • Stock valuations are not justified by this year’s earnings growth.
  • President of Praetorian Capital Management sees imminent crash. 

What it Means for Investors

Madan thinks stock market valuations are too high considering the lack of earnings growth this year. The S&P 500 is up more than 16% this year and yet earnings growth in 2019 has slowed, precisely the opposite of what one would expect. The forward price-to-earnings ratio (P/E Ratio) of the S&P 500 is currently sitting at 17.6, a level that Madan thinks is “completely unjustified.”

“This year, what you’re actually finding is that you have no earnings growth in equities and very high PEs,” he said. “An 18 times PE for a market that’s not growing—and an economy that looks primed for recession—we don’t think that’s a very good combination.”

Madan’s three strategies derive from a probabilistic, quantitative approach to investing. He begins by trying to determine at what stage the market is in its cycle and at what stage the economy is in its macroeconomic cycle. Once he’s got that pinned down, he looks at some key indicators, including the copper-to-gold ratio, global credit spreads, volatility, and the cyclicals-to-defensives ratio to determine whether to buy or sell.

Looking Ahead

Echoing Madan’s worries that a market crash is imminent is Harris Kupperman, president of Praetorian Capital Management. Kupperman believes the ultra-loose monetary policy of the Federal Reserve since the financial crisis has created an economy with a “Ponzi sector” characterized by unprofitable firms like WeWork and Tesla that only still exist because central bank liquidity has given them easy access to cash.    

“When you push liquidity through the system like they have the last ten years, you create a giant bubble,” he told Business Insider in a recent interview. “I genuinely believe there’s a crash coming.”