I try not to be an alarmist about these things, but once again world stock markets have worked themselves into a situation where there is potential for a Crash in the next few days. The converse of the headline above is that there is a 75% to 85% chance that there won’t be a Crash. But we can’t bury our head in the sand about the possibility of a Crash. So today let’s look quickly at the set-up, what has to happen to avoid a Crash, what the roadmap will be if a Crash is imminent, and what you can do to prepare if a Crash is on the horizon.

The Set-up

As I said in yesterday’s Radar Report, we have had seven straight weeks where the S&P 500 went under 1326 during the week, but then rallied to close above it at the end of the week. Going into yesterday’s trading, the S&P was well-positioned to move up and create a very strong buy signal. Instead, it collapsed at the open and kept on going down all the way to the close, which was well under 1326. After bouncing convincingly from closes at 1326 on February 6 and March 4, this was the lowest close for the entire move down and a definite breach of the critical 1326 level. If there is not a significant bounce today, the weekly chart will be badly damaged.

In overnight trading, I am seeing weakness everywhere. Other countries are worried about the exposure of their financial institutions to the U.S. sub-prime mess, and they have already seen problems surface. They are also worried about a U.S. recession dragging down their economies by weakening exports. But in addition to the credit and recession worries that these countries share with the U.S., they are also worried about the weak dollar impacting profit margins at exporters and throughout their supply chain. Case in point, Japan’s Nikkei 225 Index fell 3.3% last night as investors sold exporters’ shares, because the dollar dropped to a three-year low against the yen during Asian trading.

Avoiding a Crash

So with foreign markets already falling, what can the American markets do to avoid a Crash? Quite simply, the S&P 500 has to get back above 1326, preferably today, and certainly by Monday or Tuesday. This has been a very difficult market to trade, as it seems to want to shake out every bear with rallies up to 1370, and then every bull with sudden drops under 1340. It could be that yesterday’s move is a massive fake-out, sucking in the last of the bears’ money before snapping the trap and heading up 150 points or so. That even seems likely, given the factors that I covered yesterday: Extremely negative sentiment, high short selling, record cash positions and a Fed determined to avoid a serious downturn.

But the bottom line is that while all those factors are positive, the market has to respond or they don’t mean a thing. There is an important support level at 1295 and another one at 1270. If the S&P spikes down to one of those levels, quickly recovers and then climbs back over 1326, we will know the big, multi-month upmove is underway. I’ve been holding out March 22 as the likely date for a big turn, and that would fit with a move back over 1326 now that extends to 1370 again, one last test back down towards 1326, perhaps stopping in the 1330 to 1340 range, and then the big turn up to new highs for the rest of the year and on to April 2009.

The Roadmap to a Crash

If this scenario doesn’t hold up, what should we watching to signal that a Crash is imminent? Again, this is pretty simple. A rally back to 1326 that fails quickly from there would be a very, very bad pattern right now and that would be the time to take protective measures. We could see such a rally today or, more likely, on Monday. So it isn’t the spike down to 1295 or 1270 that you should worry about, it’s a quick failure of the subsequent rally back towards 1326.

If the S&P does spike down all the way to 1270 today or Monday, and then bounces and fails below 1295, I would say a Crash is imminent.

What to Do

I still think that the big upturn is coming this month, but the market is in a precarious position for the next couple of weeks. Accelerated down moves tend to come at the end of consolidations or downturns, and they can cover a great distance in a short amount of time. If there is a Crash, the upturn could come from much lower levels, like 1180 or even 1000.

If you are a long-term investor and can ride it through, you don’t have to do anything. We own the right technologies and the right stocks for the New World of always-on, always-connected consumers, better healthcare, higher energy costs and more security. As worries about the credit crunch and a recession fade, as they will, I expect our stocks to lead the broad market in a strong move up into next April.

However, if you want to ease the pain of watching a potential short-term, sharp decline, or even trade a downturn, here’s what to do:

• Get off margin;
• Don’t buy any more stocks until you see the market clear the 1326 level;
• Buy short-term protective puts IF you see a rally that quickly fails at 1326 or, if there is a spike down to 1270 followed by a rally that fails at 1295.

The March option contracts expire on Thursday, March 20, because Good Friday is a holiday and the markets will be closed. So I would buy an April put contract on the S&P Depository Receipts (SPY), known as the SPDRs, pronounced “spiders.” The strike prices from 110 to 129, which are probably the ones that will be of interest, all have the symbol SPY and the month code P, for April. The strike price codes run from F for the 110 strike price to Y for the 129 strike price. Buy the strike price closest to the current price of the SPY at the time you make your move. For example, if the S&P 500 fails at 1326 and is sitting at, say, 1290, you would buy the 129 contract, symbol SPYPY. That contract closed at $5.60 on Thursday, and each contract covers 100 shares, so one contract would cost you $560 and protect $12,900 of portfolio value. It isn’t cheap, but it is insurance.

If the 15% to 25% chance of a Crash happens and the market drops, I will send you another Flash Alert after the protective put options trade triggers, followed by another when you should close the position.