Last week's market tumble was in some ways reminiscent of the record-breaking Dow plunge of 778 points on Sept. 29, 2008 after the U.S. House of Representatives rejected a $700 billion bail-out package for the banks just two weeks after Lehman Brothers filed for bankruptcy protection. After that, it was all downhill for five months.
The difference is that this time there was no single event to trigger the massive sell-off. Rather, it seemed to be a culmination of months of bad news, from the seemingly perpetual sovereign debt crisis in Europe to the faltering U.S. economy. The debt ceiling crisis in Washington, which at times looked like a political reenactment of the classic movie High Noon, further eroded investor confidence even though a last-minute deal was cobbled together.
It has often been said that stock markets are leading indicators in that they reflect where the economy is likely to be in six months, not where it is today. If that's true - and it has proven to be so many times in the past - we could be headed for another recession.
Should that be the case, expect it to be even worse than the last one. In 2008-09, governments around the globe threw trillions of dollars into the economy with a wide range of stimulus packages. Traditional free enterprise nations like the U.S. and Great Britain invested heavily in banks, mortgage companies, and even automobile manufacturers in an effort to keep the world from falling into a full-scale depression. It worked, at least temporarily. But now governments are out of ammunition, with some on the verge of declaring bankruptcy themselves. There's no money left to throw at the problem.
Neither is there any room left on the interest rate side. The U.S. federal funds rate has effectively been at zero for past couple of years. The Federal Reserve Board could launch another round of quantitative easing (QE3) but it's questionable how effective that would be.
About the only other option is to turn on the printing presses and flood the global economy with cash. That would drive up inflation, which eases the debt strain by enabling bond issuers to pay off their loans in devalued currency. But it would also have the effect of decimating the savings of millions of people and creating major hardships in a slow to no-growth economy. The "stagflation" that we experienced in the 1970s, which eventually led to wage and price controls in many countries including Canada, is not an experience anyone wants to repeat.
So we may have no choice but to tough it out for however long it takes to stabilize the situation. To be realistic, that is not going to happen quickly.
In the issue of June 20, I warned that there was trouble building and advised moving a reasonable portion of your assets into fixed-income securities, if you had not already done so (IWB #21122, A Summer of Discontent). To maximize capital protection, I specifically recommended short-term securities such as the iShares DEX Short Term Bond Index Fund (TSX: XSB). At the time, it was trading at $29.05; it closed on Friday at $29.33 and pays a monthly distribution of $0.075 to $0.08 per unit.
While building the fixed-income and cash allocation is a good short-term tactic for everyone, the mid-term approach strategy requires thought and planning. This is why you need to decide what type of investor you are.
If protecting what you have is the number one concern, you should consider keeping most or all of your assets in fixed income and cash until there is clear evidence the world economy is in a genuine recovery mode. Of course, if central banks decide inflation is the only way out, this would be about the worst possible approach (in that case, move to gold). But assuming rationality prevails, this strategy will not only protect your assets but perhaps even make a profit as well.
Want proof? On the Globeinvestor website, there is a Diversification and Bear Markets Calculator that enables you to see at a glance how the value of a portfolio can be protected by adjusting the mix of stocks, bonds, and cash during a bear market. Using the 2008-09 market collapse as an example, an all-stock portfolio would have lost 43.3% of its value from the peak to the trough. However, one that was equally divided between stocks, bonds, and cash would have dropped only 11.6%. If the equity mix were lowered to 20%, bonds raised to 70%, and cash reduced to 10%, the overall loss would have been only 3.5%. A portfolio that was entirely in bonds would have actually gained 7.2% during the worst bear market since World War II.
Another calculator enables you to see how various portfolio asset mixes would have performed over a complete bear-bull cycle. I looked at the results from August 2000, which was the start of the high-tech market collapse, to May 2008, which marked the end of the rebound that followed. Interestingly, the value of a $100,000 all-stock portfolio at the end of the period was $152,284, only about $2,600 more than a portfolio that was evenly divided between stocks, bonds, and cash. The diversified portfolio did not do as well during the bull market period, but neither did it sustain the heavy losses incurred by the stock portfolio when the market tanked.
But here's the part that I found really fascinating: an all-bond portfolio would have done best of all. Instead of losing value during the bear market, it would have gained $19,500, meaning it did not have to play catch-up during the bull market years. Its final value would have been $168,069.
To see for yourself go to www.globeinvestor.com, click on the Personal Finance tab, and then on Calculators.
If you are willing to take some risk, prepare to do some bottom feeding. When markets were at their lowest in the winter of 2009, there were some incredible values to be found. Canadian bank stocks, which had been dragged down along with the shares of financial institutions around the world, were at their lowest levels in many years. Bank of Montreal was yielding more than 11% because of fears of a dividend cut (which never happened) and there were few buyers. In retrospect, it was the deal of a lifetime.
There is a real possibility that we may see a replay of 2008-09. If so, you'll be able to buy high-quality stocks at 50 or 60 cents on the dollar. But bide your time. It took several months for that market crash to run its course. The greatest bargains only appear when most investors have given up - "capitulation" is the technical term. Or, as Baron Philippe de Rothschild put it: "Buy when there is blood on the streets".
So here's what I suggest. Everyone should reduce exposure to the stock market and increase fixed-income and cash weightings now. I cannot give precise target numbers because there are many personal factors to weigh including exposure to capital gains tax by selling profitable securities. But the more defensive your portfolio, the less you will lose if we are headed for another prolonged downturn.
If the markets follow their usual pattern, we should see a rally next week although it could be delayed a few days as investors digest the S&P downgrade of the U.S. credit rating. When it comes, that will be the time to sell off any stocks you don't want to hold during the turbulent time ahead.
Once the sell-off is over, which may not be for a few months, more aggressive investors can start picking up bargain stocks. As a general rule (and there will be exceptions) wait until the indexes have rebounded by 15%-20% before you move and confine yourself to dividend-paying blue chips. You can easily double your money in a year, as 2009 proved.
This doesn't mean you should not buy any stocks at all in the interim. There may be opportunities that we believe are too good to pass up and we'll alert you to them in the IWB (Ryan Irvine has a couple in his column today). But these will be exceptions to the broad strategies I have outlined.
I hope I am being overly pessimistic. But in this situation, I prefer to err on the side of caution.
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