“You should never play poker if the stakes seem unbearably high,” writes Jonathan Clements in today’s Wall Street Journal.

“With the Standard & Poor’s 500-stock index off 34% from last year’s peak, I suspect we have seen the worst of the stock-market decline. Still, investors should brace themselves for further losses.”

“How bad could it get in the next 12 months? The answers are downright terrifying. My intention isn’t to scare, however, but to inoculate.”

“If you are mentally prepared for the worst, you are less likely to make panicky decisions if the market really does unravel. With that in mind, here is a look into the abyss.

“Losing Value: Andrew Engel, a senior research analyst at Leuthold Group in Minneapolis, reckons ‘the downside from here is maybe another 5%’ for the S&P 500 and the Dow Jones Industrial Average.”

“But what if things got really rough? To get a handle on a reasonable worst-case scenario for the next 12 months, Mr. Engel examined historical valuations for the S&P 500 and the Dow industrials, including key market measures such as price-to-earnings multiples, price-to-book value, price-to-cash flow and dividend yield.”

” ‘If stocks go back to the lowest 25% of historical valuations, we see downside of 37% to 44% for the S&P 500 and the Dow industrials,’ he says. ‘You might see that if there was another terrorist attack on the U.S., or if there were absolutely no signs of economic recovery.’ “

“The numbers are much less alarming for smaller companies. ‘If you look at small and midcap stocks, we’re already in the bottom 25% of valuations,’ Mr. Engel says. ‘The focus of investors should really be on the small and midcap stocks. There’s less risk there.’ “

“Clifford Asness, managing principal of New York’s AQR Capital Management, also focuses on valuations. He notes that, based on history, there is a 5% chance that earnings could tumble 20% or more in the next 12 months.”

“Meanwhile, he notes the S&P 500 is still at a lofty 24 times trailing earnings. But even in a realistic worst-case scenario, Mr. Asness doesn’t think the market’s earnings multiple will fall back to the historical average of 15.”

” ‘We’ve done extensive modeling that shows that price-earnings multiples do tend to be higher when inflation and interest rates are low,’ he says. ‘Also, if earnings really do plunge, you could see a slightly higher earnings multiple as people correctly see earnings as being abnormally low. Finally, I do give some credence to the idea that investors have learned that equities have historically traded too cheaply.’ “

“Mr. Asness figures price-earnings multiples might drop to 18 from their current 24. Combine that with a 20% decline in earnings and you could see the S&P 500 drop 40%. ‘Throw in an exciting 2% for dividends, and I’d call a 38% decline in the S&P 500 a realistic worst case,’ he says.”

“Mr. Asness hastily adds that this is not his forecast. ‘This is what might happen if everything that realistically can go wrong does go wrong,’ he says. ‘I’d be very shocked if this came to pass. While we still think stocks are expensive, we’re forecasting a flat to slightly positive return for the S&P 500 for the rest of the year, based on short-term signals.’ “