Saturday, January 27, 2018

After the 'Melt Up'

Steve Sjuggerud, one of the founders and newsletter writers at Stansberry Research, one of the world’s largest digital newsletter publishers has used the term ‘Melt-Up’ for the last euphoric stage of a bull market.  I am a life-time subscriber to Stansberry and although I don’t always agree with them, they are the best investment educator I have encountered in my 40 years of investing. Porter Stansberry, the other founder is also an investment visionary who as one of his favorite statements has told us that it doesn’t matter how much he wants to teach us about investing, we, their clients, have to be willing to learn; we have to give up bad investment habits and replace them with new, more rational and less emotional proven investment habits.  Just like this blog’s cornerstone is Asset Allocation, Porter tells everyone who listens that many subscribers want to have the latest stock recommendation that makes them overnight millionaires, but that reality is that Asset Allocation and Diversification are key to protecting your portfolio not which stocks (other than a selection based on some common sense and an understanding of a stock’s underlying value). In fact, Steve often uses ETFs in his recommendations. 

I know, not every investor can afford a lifetime subscription with Stansberry but they offer several free services and affordable newsletters that don’t hold back a lot of the really good ideas they have. There is one of my favorites: Stansberry Investor Hour – a weekly podcast entirely for free.  Then there is Steve’s Daily Wealth letter that is for free. They are excellent marketers – so when reading their promos or their free webinars hold one hand on the mouse and the other on your wallet. Not that they rip people off; they must make a living too.  In many ways the same is true for me; recognition of one’s work is best expressed in the form of money.   (I guess that is why this blog is for free ๐Ÿ˜Š).  Liberal die-hards, I have to warn you. Stansberry is associated with Bill Bonner’s Agora and they have a heavy Libertarian slant. By now regular readers may know that my thinking is also in that direction – so if you can forgive me for my political transgressions, you will be able to handle the Stansberry guys as well.

It is said that today, North America’s political spectrum is so polarized because we all focus on our own political on-line universe. Broadening your information sphere to the Libertarian Stansberry Yahoes (the latter is how Porter refers to his own crowd on the investor hour), may be beneficial.  I know, because I don’t read the National Post often but rather tolerate the Global and Mail and thus get some libertarian antidote ๐Ÿ˜Š. Yes, it is sometimes painful to read the Global Mail’s leftish drivel, but they also have the build-in antidote of Margaret Wente, a columnist I never skip.

So back to the ‘Melt Up’, the final stage of a classis secular bull market.  The term bull market is kind of vague. Typically, it is used for a period of time during which a market’s valuation rises 20% or more. A bear market is something where the market price declines by 20% or more. Corrections are markets with pricing falling around 10 to 15%. If you look at the 1982 to 2001 market; there were many bear and bull markets every so many years (every 3 to 7 years). But looking back, many consider 1982 – 2001 now as a secular or long-term bull market which came to an end with the Tech crash. Now, many see 2009 until today as a similar market, especially when you invested in the U.S. – Not so much in Canada. When everyone starts to talk about the ever-rising prices of real estate like happened in 2007 in the U.S. or today in Toronto and Vancouver, then you should get concerned. During this time many, including your barber, your mother-in-law, your friends at a party, they all talk about how smart they are as investors and how much money they made in say 'bitcoin’ or whatever the taste-du-jour is. People are becoming outright euphoric and urge everyone around them to invest also in those markets and during times like these, prices go often up like a rocket. The price graph ‘goes asymptotic’.  People lose all common sense and are afraid to be left behind. This is called the ‘Melt Up’.

In today’s market, but in particular in the U.S., stock investors are euphoric. But this is also the time that the largest profits are made until… there is nobody left to buy, and the markets are priced even beyond perfection! Absolutely nothing can go wrong or worse, even a suspicion of trouble can trigger an enormous crash like happened in U.S. real estate in 2007-2008; or at the end of the infamous tulip bubble in the Netherlands. Or… in 1929 on Wall Street. This is what I often refer to as the game of musical chairs where the last one(s) standing are holding the bag.  This is also the game that momentum investors play. Because if a market is in an uptrend, it is hard to stop.  Look at Tesla or Amazon. The problem is that these heady times are also the most profitable. Bre-X; Nortel and now the FAANG stocks do I have to go on? And yes Bitcoin – but I don’t think today is the crash it has to go probably a lot higher and its collapse will likely coincide with that at the end of the current stock market Melt-up.

Here is a scenario how it may end. The problem is that I have heard this scenario told now by many and that in itself is reason to question whether this is what truly is going to happen. It may be something else, such as a missile from North Korea; the assassination of Donald Trump; or anything else that is traumatic on a global scale. But the most quoted trigger is the arrival of the ‘inverted yield curve’. Central banks pushing too hard on the economic breaks by increasing short term interest rates (set by the central bank, especially the Fed) to a level higher than long term  5 – 10 year government bond rates (set by the market).  In most cases when this happened a recession and stock market crash follows.  The expectation is that when short term interest rates exceed long term rates then we will likely experience a major market crash with recession 6 to 18 months later. With so many having their hands on the sell trigger as soon as this inverted yield situation happens, you can bet that something else will happen.  My guess, the sell off would happen right away not 6 to 18 months later.  That is what makes this market so unstable and unpredictable. FAANG stocks and ETFs with a heavy waiting in FAANG would probably be the hardest hit.

So what to do?  Missing out on some massive profits during a melt-up that has just started? Here is my strategy. Diversify in other assets. I think a lot of the crash will also be coming from the bond market with its absurd negative real returns and even negative nominal returns. But bonds are also often safe-havens such as, hard to imagine,  U.S. and Canadian government bonds. Despite my fear for low interest rates and government indebtedness, traditionally during a stock market crash, central banks tend to lower interest rates and bond markets rise. Will that happen this time?  Compared to a stock market collapse, many may revert to this classic hedge anyway.  I wouldn’t write short term government debt off as an hedging asset class. But I see it only as a temporary shelter because the Credit Markets themselves are quite wobbly as well.

After the first shocks, consider buying gold and cash as shelter. Gold went down during 2008 but it peaked a few years later in 2011 at nearly $1900 U.S.  I am talking precious metal bullion – silver, gold, or platinum. Not the fashionable stuff like lithium or gold ETFs unless explicitly backed and convertible into gold such as Sprott’s Central Fund of Canada.  But as pointed out, you should not sell everything during a bear market and certainly not in a panic. It is panic or forced selling during a bear market rather than holding on and riding the wave of pain that causes the most damage to a portfolio.

So, this is a fragile game. You could use trailing stop losses say at 25% below the most recent market high to trigger an unemotional sale. Just sell because the market can easily fall another 25 percent or more. But this is not that much different than panic selling, and chances are that when you are in a market route you may not be able to sell until you have hit rock bottom.  So here is my approach.

During the melt-up, I will clean-up my portfolio. If you can sell speculative stuff and low-quality gambles do it during the melt-up and convert it to cash and gold. Good quality dividend paying stocks may lose a lot of value and may even be forced to cut that dividend, but chances are most will hold on and their prices are likely to recover. However, they will provide cash flow during the down turn.  I am talking the bluest of blue chips – your core portfolio holdings. But even there may be some rot, just think of Enron and lately GE. Yes, I also fell for GE but now I sold everything GE.  I am talking Canadian Banks, Brookfield, BCE, TransCanada and Enbridge and in the U.S: Johnson and Johnson or Bank of America, or Procter and Gamble.

Things with fat dividends that likely will provide you with quality cash flow during the downturn.  When prices get more and more absurd during the melt-up sell more and more. And use a bit of the money to buy portfolio insurance while nobody else is still considering a crash. The next posting I will talk about how to buy this insurance.  It is something I haven’t done before but it makes sense to me. Always remember: Nobody lost money by taking a profit. So, if you can’t sleep at night because all this makes you worried then maybe you can’t afford to lose at all and it is best to get out while you can.

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