This bull market is still rocking the house, despite the overall market being some 30% overvalued. A decline will occur, but nobody knows when or how it will happen. All we can do is speculate — and speculate we should, because we must always be vigilant for risk!

That’s the problem with most people’s portfolios — they are not designed to reduce risk, even though they think they are.

So what are the three things that might cause a market meltdown and how can you prepare your portfolio for this?

Risk abatement that is baked into a portfolio is how my stock advisory newsletter, The Liberty Portfolio, operates. It is already hedged for a crash and will be even more so as the months go on.

Crash Possibility: The Tax Cut Passes

This would be a classic example of “buy the rumor, sell the news.” The “Donald Trump Rally” has partly been in response to expectation of policy that would make life better for corporations, including a debilitated CFPB and change in tax policy.

The corporate tax cut, in particular, is what has made markets so optimistic, because it filters through the entire market. First, companies can repatriate money overseas, saving hundreds of billions of dollars. That money comes home. That, combined with a massive corporate tax cut, from 35% to 20% or so, is going to mean hundreds of additional billions that stays inside of corporations. Thus, earnings will increase.

That money also means businesses can grow, they can pay out higher dividends, and repurchase stock.

So if one believes that all this has been baked in, then the exuberance might suddenly come to a halt.

Crash Possibility: The QE Unwinding

Many people, myself included, believe the last ten years of insane increases in the stock market have been fueled by the $14 trillion of collective infusion of cash into the markets by central banks.

See this scary chart? It shows how the central banks have been gobbling up assets.

What do you think would happen when $14 trillion flows into the markets? Maybe this?

 

So as the Fed begins its unwinding, what do you think happens when the central banks start selling assets?

You should be very afraid of a crash.

Crash Possibility: Significant Interest Rate Hikes

The saying is, “Don’t Fight the Fed.” If the economy continues to improve, then the Fed is going to continue hiking rates. We’re still safe for now, with the 10-year Treasury at 2.38%. But once that gets back up to 4.5% or so, we’re going to see all those income and retirement investors who were forced into equities by the low bond yields come rushing back into bonds.

Remember, these investors want income. 4.5% or so is generous to them and to most, even 3% makes them happy, because they mistakenly believe this is the inflation rate.

How Can You Protect Your Portfolio?

The solution is NOT to reduce equities and buy bonds to prevent a portfolio crash. The secret is to entirely re-allocate your portfolio to include more alternative investments — assets that do not correlate to the overall market. That way, they move independently of what the overall market does, and thereby reduces the overall volatility of your portfolio.

Less volatility equates to less risk.

The Liberty Portfolio gets into specifics about what investments work best, but you should look at things like low-volatility ETFs, such as the PowerShares S&P 500 High Dividend Low Volatility Portfolio (NYSEARCA:SPHD) or the PowerShares S&P MidCap Low Volatility Portfolio (NYSEARCA:XMLV). Likewise, look at things like managed futures, such as the WisdomTree Managed Futures Strategy Fund (NYSEARCA:WDTI), and smart-beta funds like First Trust Long-Short Equity ETF (NYSEARCA:FTLS).

Regardless, you MUST have a holistic approach to risk for your portfolio, or real protection won’t exist.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.