3 reasons the S&P 500 could be headed for a 48% drop, according to an investment chief who crushed the market during the coronavirus crash

3 reasons the S&P 500 could be headed for a 48% drop, according to an investment chief who crushed the market during the coronavirus crash
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  • The S&P 500 could be headed for a drop of up to 48%, according to James McDonald, the CEO and chief investment officer of Hercules Investments.
  • A new strain of COVID-19, historically elevated tech valuations, and a priced-in stimulus leave the stock market vulnerable to a crash if investor sentiment suffers a sharp negative shock, McDonald said.
  • "Monday's selling pressure isn't a sign that a major market crash is imminent, but crashes do begin with shifts in short-term sentiment like we have seen in recent sessions," McDonald said.
  • He recommended investors have exposure to volatility instruments, which can offset losses in core holdings if markets fall.
  • Visit Business Insider's homepage for more stories.

The S&P 500 could be headed for a drop of up to 48%, according to James McDonald, the CEO and chief investment officer of Hercules Investments.

In a recent note to clients, McDonald, who profited from the pandemic crash in March with bullish wagers on stock-market volatility, laid out three reasons the market is especially vulnerable to such a swift downturn right now.

1. A new strain of COVID-19 in the UK

The perceived future harm of the new COVID-19 strain in the UK will introduce additional risk to markets, according to McDonald. That's especially true since recent progress on vaccines led many investors to expect a smooth return to normal life following their rollout, he said.
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"The new strain is one of many potential catalysts that can shift sentiment and trigger violent selling, especially as stocks hit record highs as recently as Friday," McDonald said.

2. Historically elevated tech valuations

McDonald said recent valuations in the technology sector exceeded levels in the days and weeks before the major market crashes of 1929, 1987, 2001, and 2008.

"The idea that tech stocks should keep rising in the face of the Covid-induced headwinds was an idea rooted in historic optimism," he said. "As we see now, eventually reality strikes and changes things overnight."

Read more: Bank of America unveils its top stock pick in each of the 11 S&P 500 sectors and explains why they're poised to dominate in the year ahead
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3. The stimulus package isn't enough to offset the economic fallout of COVID-19

The $900 billion stimulus package is necessary and was largely expected by investors - but it won't be enough to limit the economic fallout of the pandemic, according to McDonald.

Given these circumstances, McDonald said, the S&P 500 could crash to 1,900 if investor sentiment suddenly turns negative. The Dow Jones industrial average could drop to as low as 15,000, a roughly 50% drop from current levels, he added. Markets have always crashed in the weeks and months following 52-week highs, and it could take only a change in sentiment to trigger a large sell-off, the investment chief said. Both the Dow and the S&P 500 closed at record highs last week but have pared gains.
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"Monday's selling pressure isn't a sign that a major market crash is imminent, but crashes do begin with shifts in short-term sentiment like we have seen in recent sessions," McDonald said.

He recommended investors have exposure to volatility instruments, which can offset losses in core holdings if markets fall.

"Risks here are as high or higher than potential gains, so it only makes sense to have a defense in place," McDonald concluded.
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