Sunday, June 29, 2014

By The Way: What about the next bear market?

I listened to an interview of David Stockman and it was sobering.  He was interviewed by Porter Stanberry famous for his ‘The End of America’ infomercial – these guys are two peas in a pot. Porter may say things in a more sensationalized way while David is more subdued. But the message is the same… and you have probably, like me, heard the story about government debt many times before. Yet, that does not mean that we should ignore it.

What caught really my attention this time was the total disregard both man had for the Federal Reserve. Basically Stockman stated that the current printing of money is financing current government debt at an artificially low interest rate, costing around $250 billion per year. Once rates normalize though, these costs likely increase to $750 billion or a mere ¾ TRILLION dollars per year. That would be nearly 6% of the US GDP!
So when is interest returning to normal?  That may not be as far away as many of us think. The Federal Reserve itself is talking about a Feds Fund Rate of 1.25% in 2015 and 2.5% by 2016. Mind you, stock markets don’t necessarily crash; in fact these interest rates are still low and if anything they indicate stronger economic performance.  However, based on historical data, once interest rates exceed 4% or so the story changes rapidly and stock performance is likely to deteriorate with each further increase. Here is another way of looking at it: historical inflation rates are around 3.5 to 4% and short term interest rates are typically 0.5% or so higher than inflation. Since markets over the long term go more up than down you can expect under such conditions average stock market performance. But if inflation and thus associated interest rates, rise further stock market performance typically deteriorates.
If nothing is done about U.S. government debt and government debt in general, the interest payments by government will sooner or later become onerous and a major drag on the economy.  In the meantime, investors may wonder whether they want to keep on investing in those over-indebted governments and one day, possibly not that far in the future, they may stop lending to governments altogether.  If you think that governments don’t default on debt anymore, look no further than Argentina right now. Many governments, including China’s, have a house-of-cards type of national finance system. Gold, as a currency without strings attached, may better hold its value than any piece of national fiat money. With gold trading so far below its 2011 peak of $1900, here may be an opportunity to diversify you portfolio  and protect yourself against potential government debt and associated currency crises.
The problem in a major bear market is that you need ‘cash’ to buy assets when assets are cheap. But if the bear market is due to a confidence crisis in government debt, then what is your protection against a simultaneous loss of purchasing power of crashing currencies?  Right, gold is likely one hell of a hedge.  I am not saying to convert all your stocks into gold right now. In fact, owning assets such as stocks, real estate and commodities, including gold’ are often great hedges against inflation – but having a small portion of your portfolio, say 5 to 10% in gold may be a prudent hedge if the next bear market is caused by a collapsing bond market.  Oh… with interest rate spreads between government debt and corporate debt at a minimum, don’t think you’re safe in the corporate bond market either.
For the near future, I only see an improving economy in both North America and Europe.  China is not far behind.  So for now, let you profits run, but as discussed in earlier posts: use stop loss triggers, and consider selling call options or do collared options to force you to sell in case of a rapidly dropping stock market. Earlier this year, I expected a bull market peak in the first or second quarter of 2015. This may prove a bit early – I feel now confident enough to see this bull market last another year or maybe even another two years, which would make it one of the longest bull markets of the last 150 years. So, stay wary and don’t take anything for granted – let profits run, but also build cash up to at least 20% of your paper securities portfolio and when prices get even crazier, don’t be afraid to increase your cash holdings.

BTW right now looking in a crystal ball, government debt may be at the core of the next market crash, but don't forget that bear markets are often triggered by 'black swan' events such a major terrorist attack, a war in the Middle East or in the Ukraine or between China and Japan or... what the heck do I know? it is a black swan event after all!  J
BTW BTW During economic downturns a good investor looks for 'green sprouts'; during good times he/she looks for clouds at the horizon (things to worry about).

BTW BTW BTW I have a strange sense of humor!


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