5 reasons investors should start preparing for stock market losses

• Investors should take advantage of the recent rally in stocks and prepare for losses by buying insurance, according to Goldman Sachs.
• The bank said the narrow leadership from mega-cap tech stocks means the downside risk is elevated.

Stocks have been on a tear since the S&P 500 bottomed in mid-October, jumping more than 25%, but Goldman Sachs believes now is an opportune time for investors to hedge their portfolio against future losses.

The bank recommended investors prepare for a stock market sell-off of as much as 20% within the next few months because of a potential recession.

"Some portfolio managers expect a recession to begin within the next year, a view that is consistent with most economic forecasters. In that scenario... the index could fall by 23% to 3,400," Goldman Sachs' David Kostin said in a June 20 note.

Given the strong stock market rally, combined with a potential recession within the next year, Kostin highlighted five reasons why investors should buy insurance for their portfolio now.

1. "Downside protection is attractively priced."

"While investors were well hedged from March to May, investors started paying higher prices for single stock calls in late-May and index call buyers joined in starting on June 2nd. We find these measures of put-call skew are contrarian indicators for forward market performance, and they clearly show investors have bought upside asymmetry in stocks and indexes. With investors already bullishly positioned, it may be harder for the market to rally further from here."

2. Narrow market rally suggests drawdown risk is elevated.

"Historically, sharp declines in market breadth have typically been associated with large drawdowns in subsequent months. One of our market breadth indicators compares the distance from the 52-week high for the aggregate index vs. the median stock. Market breadth has recently narrowed by the most since the Tech Bubble on this measure."

3. Valuations are high in absolute and relative terms.

"The S&P 500 trades on an NTM P/E of 19x, which represents the 88th percentile since 1976. Historically, when the index has traded at this level or above, the S&P 500 has experienced a median drawdown of 14% over the next 12 months as compared with a 5% drawdown over a typical 12-month period."

4. Equities already price an optimistic outlook.

"Our economists expect US GDP growth will average 1.0% during 2H 2023. However, as measured by the performance of cyclical stocks relative to defensive stocks, the equity market implies a pace of economic growth of approximately 2%."

5. Positioning is no longer a tailwind to equities.

"As 2023 has progressed, investors have increased their equity exposure. Hedge funds increased net leverage, mutual funds cut cash balances, and foreign investors have been net buyers of equities. At the latest reading, the SI registered a 114-week high of +1.2, suggesting that light positioning should no longer be a tailwind for the equity market. There are many reasonable alternatives to equities today, indicating that the flow of funds is unlikely to be a tailwind for stocks this year. "

Kostin's view on sentiment and investor positioning was reinforced Wednesday by market veteran Ed Yardeni, who highlighted in a note that there might be "too many bulls."

"The bull/bear ratio compiled by Investors Intelligence jumped to 3.00 during the July 4 week, up from 2.69 the previous week. It is the highest reading since the bull run from March 23, 2020 through January 3, 2022," he said. "High bullish sentiment can be a caution flag."