14 Mar 2014 Is the market going to crash, and other concerns?

We’ve had a number of questions lately reflective of the times, ranging from fear to hope to outright optimism. There have also been a lot of questions about investment choices and what to believe from all the hype lately.

Is the market going to crash?  –  Short answer: Yes, but when is the bigger question?

Wikipedia defines a crash as a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. That paper wealth does not translate to real loss of wealth until stock holdings are sold.

The most famous crash occurred in 1929 at the outset of the Great Depression. Stocks ‘declined’ 40% in a year. The most recent crash occurred in 2008 when stocks declined 37% that year. Two other crashes of note were the crash of 1987 and the Nasdaq or Tech Wreck of 2000 (down nearly 70% for that index). Crashes are different from bear markets in that they are shorter and more furious because of panic selling. A crash does not necessarily bring on a bear market.

When is the next crash coming? Short answer: Good question.

From the previous market peak in October of 2007 to the latest peak as of 2/28/2014, stocks are up 44.1% (including dividends). But that is just under 6% annualized. If you were a great market timer and got in at the market bottom on March 31, 2009, then you are now up 159% or 22.5% annualized. The big difference depends on when you get in and when you get out.

So why not get out of the market before it falls and get back in when it’s low? Short answer: A good strategy if you are a professional gifted in macro-economics and a sixth sense for when tempests of panic pop up. There aren’t many of these and most made their fortune by understanding the trading patters of isolated sectors of the market.

The strategy is virtually impossible for individual investors mostly because emotions frequently enter into decisions causing costly behavioral mistakes. For instance, cash flows demanded on the investment pool have emotional purposes (education for children, retirement income etc.) and cannot be viewed objectively as a professional views his investment pool (which are all too often funded by money planned for retirement and other important life purposes). Individuals are otherwise employed in life and vocational activities and cannot focus full-time on all the variables that impact investments. Success, often luck, creates a false sense of competence. And not inconsequentially, transaction costs such as taxes and expenses substantially erode profits, particularly if the practice is followed over a lifetime of costly moves into and out of markets.

What if interest rates go through the roof? Short answer: Stocks and the economy will decline, maybe.

First let’s deal with the Federal Reserve, the current largest driver of interest rate moves. As the Fed undoes it’s QE3, which was designed to boost the economy, by slowing and eventually stopping the purchase of US Treasuries, Treasury prices will fall and their rates will rise. Anytime a big buyer leaves a market, unless replaced, prices generally fall. Treasury prices have fallen 6.5%, as measured by the Barclay’s 7-10 year US Treasury Index, since Fed Chair Ben Bernanke said the Fed would soon begin unwinding its buying program. Stocks, by the way are up 19% since that time as measure by the CRSP Total US market index.

In normal markets, inflation is generally the most significant driver of interest rate increases. A couple of periods in US history provide examples of what happens when when inflation flares. From 1973 to 1975 12-month CPI jumped from 3.41% to 12.34%, before settling in at 6.94% by the end of 1975. 7-10 Year Treasuries did not lose more than 1.82%. and averaged a compound return of 5.4%. Stocks suffered a rolling 12-month loss of 41.5% and an annualized  loss of 6.9%.

From March of 1978 through February of 1982 the trailing 12-month CPI inflation gauge jumped from 6.55% to 14.76% before settling back to 7.62%. This time the 7-10 Year Treasurys gave up 9.45% in a 12-month period, but still managed a compound annual return of 2.74% during the four-year period. Domestic stocks, during their worst 12 month period gave up 8.9%, but managed a 14.72% compound annual return.

So what about gold or other alternative hedges for stock risk? Short answer: Most alternative hedging strategies benefit those selling them for more than those investing in them.

We believe US Treasuries represent the very best hedge against stock market risk for a number of reasons.

• Treasuries trade in the most liquid market in the world.
• Frightened investors run to Treasuries more than any other asset class when uncertainty about domestic and global economy and security flares
• No one has ever lost a penny investing in US Treasuries if held to maturity.
• The 7-10 year Treasury index has never lost more than 9% in a given 12-month period. And it has never had back-to-back 12-month losses.
• As insurance, it is cheap. An ETF representing the 7-10 year index (IEF) is available with an expense ratio of only .15%. This expense is a fraction of the cost of other alternative hedges such as gold, real estate, or commodities. And you get paid while you hold it rather than paying someone else to hold it for you. And it is not nearly as volatile as the other hedges.
• Finally, we do not own Treasuries for their income production. People go wrong when they seek income from bonds because they set themselves up for decaying income. Inflation destroys spending power over time. Dividends paid by profitable and growing companies (broadly diversified) offer the best source of income. What about the volatility of stocks you ask? – offset it with US Treasuries!!

A picture is worth a thousand words. Take a look at how the “alternatives” did in 2008 relative to the 7-10 Treasury.

Source: Wealthcare Capital Management

Be wary of the promises of alternative hedging strategies and count on US Treasuries. While we hope crashes like 2008 aren’t coming anytime soon, wouldn’t you sleep better knowing you have the best equity-risk hedge available to investors, according to the panic experts of 2008?