How are you preparing for a possible market crash in 2024?

Who is David Einhorn you ask? He’s a famous investor with a very good long-term track record. If you Google him, contrasting articles will show up – a few showing him in a good light and others criticising him for having a few bad years. On the whole, though, the billionaire investor has done quite well for himself. 

A big reason for Einhorn's longevity is his ability to change his mind and make significant changes to his investment policy in the face of strong evidence.

One of my favourite Einhorn stories dates back to 2009, when he gave a presentation at the Value Investing Congress. Einhorn recalls how he had recommended a home builder stock in the middle of the housing boom. His rationale was that the stock was not as risky than its peers as it had less leverage and owned less land.

And for a while, he was indeed right – the stock quickly shot up 30% within a couple of months. However, it was all downhill from then on.

We now know how the US housing bubble burst, courtesy the sub-prime crisis, and how stocks across the board collapsed. Needless to say, Einhorn's stock also collapsed, delivering a 40% loss over five years for anyone who acted on Einhorn's recommendation.

Was the 40% loss a consequence of bad analysis or bad luck? A strictly bottom-up investor would dismiss it as bad luck as almost no one could have predicted the housing bubble in advance.

Had the bubble not burst, investors could have made a killing on Einhorn's recommendation, so Einhorn was simply unlucky here, they would say. Einhorn himself did not agree with this, though. He called it bad analysis instead of bad luck.

And what made Einhorn think this way? A super investor who answers to the name of Stanley Druckenmiller.

You see, the very same day Einhorn made his stock recommendation, Druckenmiller also made a presentation. But his presentation wasn't a bottom-up analysis of a stock. It was a top-down analysis of the bubble that he felt was brewing in the real estate space.

He explained in gory detail the big picture problem the country faced from an expanding housing bubble fueled by a growing debt bubble. Einhorn was present when Stanley made his presentation. However, he chose to ignore it, simply because he believed that even if Stanley was correct, it would be very difficult to make money from this top-down analysis as such events were almost impossible to time.

Einhorn chose to look the other way as he felt that even if Stanley was right, there was no way to know when he would be right. As per Einhorn's own admission, it was an expensive error.

Stanley's prediction came true within a couple of years, and we witnessed one of the biggest financial crises of all time. Einhorn's ignorance cost him dearly, but to his credit though, he acknowledged his mistake and made appropriate changes to his investment strategy.

In his own words...

“The lesson that I have learned is that it isn't reasonable to be agnostic about the big picture. For years I had believed that I didn't need to take a view on the market or the economy because I considered myself to be a "bottom up" investor.

“Having my eyes open to the big picture doesn't mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time."

Einhorn's current bet on gold shows he has indeed walked the talk since then. While he remains a bottom-up stock picker, he believes that it is very important to protect capital in the face of foreseeable risks.

Taking cue from David Einhorn, how are you preparing for the possible macro risk that could lead to a stock market crash in 2024? What insurance are you thinking of buying?

Well, I will tell you what I am going to do.

Like Einhorn, I am a bottom-up stock picker. And like his new avataar, I am keeping my eyes and ears open to the big picture. Unlike Einhorn, though, I am not relying on gold but cash.

Yes, that's right. The cash or fixed deposit (FD) component that I insist on having for the majority of my offerings is insurance against a big market crash. It not only helps minimise losses during a crash, it also makes funds available to buy stocks on the cheap.

In fact, this component has already rescued me a few times. The reason my subscribers were able to lose less than the broader market in the smallcap crash of 2018 or the covid crash of 2020 was because we had a large part of the corpus in FDs, which we started deploying aggressively after the crash. We were able to be greedy when others had turned fearful.

We don't mind continuing with this strategy even though it may hurt our performance in a bull market like the current one, for we know that when a crisis strikes, which it eventually will, this insurance will be worth its weight in gold.

We are willing to bear short-term pain for long-term gain. Like Einhorn, we aren't abandoning bottom-up stock picking, but we aren't being agnostic about the big picture either. We always keep at least 25% of the corpus in FDs at all times and then adjust this allocation upwards based on the broader market valuation. If the broader market is expensive, we increase the FD component and if it turns cheap, we reduce it and increase our allocation to stocks.

This has served us well in the past and there's no reason why it shouldn’t do so in the future as well. 

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com