Can Investors Protect Themselves Against a Stock Market Crash?

The prospect of a significant stock market crash is a recurring concern for investors, particularly when valuations appear stretched across major indices. While predicting market downturns with certainty remains impossible, history offers valuable lessons and data points that can guide defensive positioning. Understanding these signals and preparing a resilient portfolio may help mitigate risk if such an event occurs.

The Valuation Question: When Do Stocks Become Overpriced?

Current market conditions have sparked legitimate debate about whether equities are trading at unsustainable levels. The concern centers partly on the artificial intelligence sector, where leading companies have seen extraordinary share price appreciation in recent years. While the technology itself is transformative and companies at the forefront are capturing real economic value, some participants argue that valuations have outpaced fundamentals.

One reliable metric for assessing this is the CAPE (cyclically adjusted price-to-earnings) ratio, which smooths earnings volatility by looking at average profits over a full business cycle. The current reading sits just under 40, a level that warrants attention. Historically, the last time this valuation measure reached such heights was during the dot-com bubble of the late 1990s—a period that eventually gave way to a severe market correction. The Shiller CAPE ratio data reveals this pattern clearly, suggesting that elevated valuations today bear some resemblance to conditions that preceded past downturns.

This doesn’t guarantee a stock market crash is imminent, but it does indicate that market participants should maintain appropriate caution and consider whether their portfolios are positioned defensively enough.

Lessons From History: What Past Market Corrections Tell Us

The dot-com bubble provides perhaps the most instructive historical parallel. At that time, investors were captivated by new internet technology much as they are today by artificial intelligence. Share prices of tech companies soared to levels disconnected from earnings, and when the correction finally arrived, many stocks lost 60-80% of their value over several years.

Yet not all stocks fared equally during that downturn. Companies with strong competitive advantages, stable cash flows, and essential products proved more resilient. Defensive sectors like healthcare and utilities weathered the decline better than high-growth technology stocks with minimal profits.

This historical lesson suggests that a stock market crash, should one occur, would not be uniform in its impact. Selective positioning in fundamentally sound businesses could help reduce portfolio decline during volatile periods.

Strategic Positioning: How Investors Can Prepare Today

Rather than attempting to time the market—a notoriously difficult task—a more prudent approach is to ensure your portfolio reflects appropriate risk management. This means identifying companies that appear undervalued relative to their long-term earnings potential and competitive positioning.

The pharmaceutical sector offers one compelling area of focus. While healthcare stocks have experienced recent underperformance, the sector contains companies with substantial pipeline potential, established revenue streams, and valuable intellectual property. These characteristics provide downside protection if broader market corrections occur.

Additionally, companies implementing efficiency-enhancing technologies like artificial intelligence can reduce their cost structures while maintaining revenue, an attractive combination from both growth and defensive perspectives. When valuations reset lower, such operationally efficient companies often recover faster than operationally challenged competitors.

Case Study: Why Defensive Positioning Matters in Vulnerable Markets

Consider pharmaceutical giant Pfizer (NYSE: PFE), which trades at approximately 9 times forward earnings compared to the healthcare sector average of 18.6. This significant valuation discount suggests meaningful margin of safety.

Pfizer has faced headwinds in recent years, including revenue pressures and upcoming patent expirations on key medicines like Eliquis (an anticoagulant) and Xtandi (a cancer therapy). However, the company possesses a deep drug pipeline spanning large therapeutic areas including oncology and weight management. Management is systematically deploying artificial intelligence to reduce operational costs while investing in next-generation products.

The company’s earnings resilience, despite revenue challenges, indicates underlying business stability. As new products launch and top-line growth eventually stabilizes, the stock appears well-positioned for recovery. More importantly, if a stock market crash centered on artificial intelligence valuations were to occur, defensive healthcare holdings like Pfizer would likely experience less severe declines than the broader technology sector.

Beyond Single Stocks: Building a Balanced Approach

While specific stock selection matters, investors shouldn’t rely on identifying individual winners and losers. A diversified approach that emphasizes quality, value, and defensive characteristics tends to outperform over extended periods, even when market corrections interrupt short-term gains.

The Motley Fool’s Stock Advisor service identifies companies meeting multiple quality criteria for investors seeking a curated approach. Historically, this discipline has delivered compounded returns of 932% since inception, substantially outpacing the S&P 500’s 197% return. Past recommendations like Netflix (recommended December 17, 2004, which would have turned $1,000 into $446,319) and Nvidia (recommended April 15, 2005, which would have become $1,137,827 on the same investment) demonstrate the value of quality selection even during periods of market volatility.

The key insight is that a stock market crash, while disruptive short-term, creates opportunities for well-positioned investors. Rather than attempting prediction, focus on building a portfolio of fundamentally sound companies trading below intrinsic value, diversifying across defensive sectors, and maintaining sufficient dry powder for deploying capital when opportunities arise.

(Returns as of February 3, 2026.)