Stocks and Shocks: what to do?
David R. Kotok
April 29, 2012
How do we avoid walking into a “left hook” in the markets? That was the discussion this week during a client review. “Can’t you see them coming and avoid them?” he asked.
Well maybe some folks can, but the issue of investing with possible shocks as an outcome is a very difficult one. Do you position for the worst outcome? If yes, you would never invest in anything. Do you anticipate the best outcome? That seems foolish. Is there a middle road? We think so and that is why we use a combination of ETFs and bonds. That is why we recommend diversifying risk among several asset classes.
Below this introduction is a partial list of upcoming potential shocks. As readers will note, we can see the potential shock relatively clearly. Scott MacDonald of MC Asset Management calls them “dangerous seas ahead.” His maritime metaphors sequence the Titanic and the Lusitania. Lehman-AIG and the meltdown were the Titanic. “This leaves us to wonder if the US economy is not like the Lusitania, operating in a high risk environment, but felt to be safe from prowling German U-boats in the North Atlantic.” ponders Scott.
Of course, we cannot know the result of a potential risk before it happens. We cannot know the outcome and the policy shift. Therefore, the anticipatory period preceding the risk and the aftermath, if as and when the risk is realized, are not symmetrical. In other words, you are investing in asymmetry. Knowing this in advance allows an asset-allocation rebalancing as the circumstances and probabilities change. In other words, reassess, reassess, reassess risks and rebalance, rebalance, rebalance.
Some of the discussion in our new book addresses these types of asymmetries. See Amazon.com, From Bear to Bull with ETFs or click on the book cover shown on Cumberland’s website, www.cumber.com. In the book, we actually show the comparison with the ten sectors of the S&P 500 index and the relative performance of each sector in the bear and in the subsequent bull market.
Now let’s get to some potential shocks and comment about them.
Possible shock number 1. The Fed will cease “Operation Twist” on June 30. They confirmed the policy shift as recently as this last meeting and Bernanke’s statement. What will a twist cessation bring to bond yields? Will it change home mortgage interest rates? Delay a housing market recovery? Alter the steepness of the yield curve? Or the flatness of the yield curve? What happens to bond credit spreads? Pricing of repo collateral? Maybe the whole thing will pass as a non-event. Nobody knows.
Possible shock number 2. The so-called “fiscal cliff” is approaching at year-end. Strategas’ Dan Clifton and Jason Trennert have hammered this theme. Their summary identifies three elements: “… roughly one-third of the entire tax code expiring at the end of the year, the spending sequester beginning on January 2, a debt ceiling increase needed in the six weeks after the election and before the end of the year.” How much will markets anticipate these outcomes? How deep is fiscal drag? Is there a fiscal drag? Is Ricardian equivalence dead? How large is the policy shift danger to our country from the Congress? From this president? From next year’s president, re-elected or new? All of these tax-spend-borrow outcomes are probable in the present-day realm of American politics. That puts our American destiny in the hands of a class of people who are very unpopular and despised by the majority of American citizens. Our politicians have become the scurrilous, scatological scoundrels that we elect and send to Washington. We include both political parties in this opprobrium. Jack Bittner asks if we should limit all pols to a single term.
Possible shock number 3. The Bank of Japan has leaped to the top of the G4 central banks when it comes to balance-sheet expansion. BOJ announced an increase in the rate of asset purchases and an extension of the duration of the Japanese sovereign debt it will buy. Initial market reaction was that this plan is “not enough.” BOJ is trying to get Japan’s inflation rate UP! They have not succeeded in the past. Is this time different? What will be the impact on the foreign exchange markets? Will the yen weaken? If so, which currency will strengthen? We have written in the past that FX market adjustments are quite distorted when the G4 central banks are all maintaining their policy interest rates near zero.
Possible shock number 4. The FDIC limit on non-interest-bearing demand deposit insurance is scheduled to revert back to the pre-crisis level at the end of this year. We quote from the FDIC website: “From December 31, 2010 through December 31, 2012, at all FDIC-insured institutions, deposits held in noninterest-bearing transaction accounts will be fully insured regardless of the amount in the account. For more information, see the FDIC’s comprehensive guide, Your Insured Deposits, at www.fdic.gov/deposit/deposits.” What will be the impact in the money-market end of the yield curve? Will there be an extension of the termination date if markets begin to tighten? What will happen to repo rates? Repo collateral pricing? How closely is the Fed watching this development, since the Fed has been providing the market with more repo collateral (T-bills) through its Operation Twist? Is there a relationship, or will there be one? Can the banking system withstand larger withdrawals of zero-interest deposits if corporate agents deem deposits to be insecure without FDIC insurance coverage? Note that the FDIC just closed five more banks this week. In the case of the Bank of Eastern Shore, Cambridge, Maryland, the FDIC has not found a buyer or merger partner, and the uninsured depositors are at risk of loss. Readers who are still worried about the safety of their bank deposits may check the FDIC website for the current rules.
Possible shock number 5. Watch the price and futures prices of Brent crude. Many are sanguine about oil and energy pricing and the gasoline price. We are not. Libyan production is not coming back in a hurry (hat tip to Barclays for superb research on the risk of Libyan civil war). Geopolitical risk is high in the Persian Gulf (Iran) and in Nigeria (see the developing news story of turmoil in this important oil-producing country). Worldwide demand for oil inexorably rises. US energy policy still fails to accelerate our move to energy independence. Despite Energy Secretary Salazar’s protestations, the fact is that the Obama Administration has a failed energy policy and continues to pursue it. We do not drill, we do not encourage the use of natural gas in an accelerated and proactive way, and we do stymie new production and exploration. We do have pipelines running in the wrong directions, and we do have distorted domestic oil pricing because of excess inventories in Cushing, Oklahoma. At Cumberland, we remain attentive to this sector even as the market has become sanguine about it. We continue to hold our oil-energy-exploration and oil-service positions. The range of forecasts of the oil price is a mile wide. We have seen a low of $40 a barrel within two years and a high of $175. We lean to the higher price, not the lower one.
I will stop now with the list of possible shocks and leave it to the reader’s imagination to complete this compendium with thoughts about Europe or China slowing or future inflation risk.
Here is how we see the portfolio management decision. Remember this is today. It could change tomorrow, next week, next month or next year. The operative structure is reassess, reassess, reassess, rebalance, rebalance, rebalance.
Cumberland continues its fully invested approach using ETFs. We have been in that mode since the bear-market bottom of October 3. We think the bull market that started on October 3 is only half over as to price change and only one-third to one-fourth over as to time. Of course, any shock could derail this forecast.
Our bond portfolios are slowly repositioning to a hedged or defensive mode. We have time. The process of moving from the present very low interest rates will require years and be volatile but gradual. Interest rates cannot go below zero. To get them above zero and into a more normal relationship, the G4 central banks must neutralize over four trillion dollars equivalent of excess reserves. Collectively they are still enlarging this position and are a long way from extraction from it.
Two items are recommended. Read “Death of a Theory,” by St. Louis Fed president James Bullard, in the March-April/2012 monthly bulletin of that bank.
For analysis of last year’s bear market and the ensuing bull market, readers may wish to consult our new book, From Bear to Bull with ETFs. We thank readers for their response so far. For the first time in our life, we have had a three-week-running best-selling book.
David R. Kotok, Chairman and Chief Investment Officer