Have You Protected Your Retirement Nest Egg from a Crash?

Assuming that fundamental analysis is correct then stocks are overpriced and are due for a reduction in price. Stocks have topped out in December instead of going up in the “January effect”, thus hinting it’s time for a crash. Some bullish people say it is normal to only have a 9% annual appreciation at this stage in the cycle, so the recent run up of 32% in 2013 may be subject to a 20% correction. Some bearish advisors feel that the SP needs to go down 37% to 1200 to reach fair value. A few bears claim a much lower estimate.

Even though the economy is stable and growing the problem is that investors have overpaid for stocks so stocks need to come down even if the physical economy gets better. If you can’t afford to make mistakes that would disrupt your retirement goals then you need to review ways to protect from bear market risk:

1. Liquidate risk-on assets and move to cash

2. Invest in investment grade bonds

3. Diversify into other risk-on assets such as EM stocks or commodities or real estate

4. Use a Long-Short market neutral Hedge Fund

The problem with number 1 is that investing in cash (short term T-Bills, etc.) pays almost nothing. This means that time will be lost when one could have made some compound interest in bonds. If you can earn 3% a year in bonds compounded over six years that’s a 19% increase after six years, before tax, compared to simply holding a money market fund.

The problem with number 3 diversifying into other risk-on assets is that in modern times all risk-on assets are closely correlated and thus suffer crashes at the same time. The global physical economy is tightly integrated as are the global financial markets. As people send their funds all over the world to invest, this changes the characteristic of foreign markets so that they end up becoming more correlated with the global economy and thus lose their past element of diversification. Commodities and real estate both respond to an improving economy as do stocks, thus they are not uncorrelated. When bad times hit then real estate and commodities can go down just like stocks.

The result of the Federal Reserve’s constant stimulus and easy money for 25 years is that there is a surplus of capital that has acted like a rising tide to lift all boats (investment assets) including foreign assets. This has created a globally interconnected market due to the fungible nature of money. When the Fed’s Taper Tantrum of June, 2013 occurred it hurt EM markets more than U.S. markets.

Diversifying between small cap versus large cap may help a little as large caps have lower PE ratios and are much better equipped to survive a brutal recession. However based on the behavior of the SP 500 in the crashes of 2002 and 2009 even large caps suffered huge 55% drops. Just because small caps are even riskier than large caps doesn’t mean that large caps area truly suitable form of diversification. Remember the slogan “two wrongs don’t make a right”. It is wrong for a stock to have a high PE ratio and if small caps are at 70 or 80 PE, which is very high, and large caps are at 25, both are overpriced and thus subject to crashing, since fair value PE is 16.

The reason why PE ratios are so high is because the Fed’s easy money policies have made investors feel there is a “Put” option that will protect them from a crash, so they are tempted to overpay for stocks. Ironically the Fed’s attempts to calm the economy over the past 25 years have created new bubbles which may result in worse crashes later on.

What investors who have a lot of risk-on assets can do is to reduce risk by ranking their risk-on assets in terms of the riskiest and also rank them the lowest potential capital gains tax and prioritizing which to sell. Paying some tax may be better than losing 50% in a crash.

By holding investment grade bonds during a crash an investor will feel more confident and thus better able to avoid the temptation to panic sell during a crash. This confidence will make it easier to buy at the bottom when everyone else is gloomy.

Investors must realize that the best outcome may be to avoid a massive 55% stock crash (like in 2002 or 2009) by holding bonds even if yields are low.

Investors need independent financial advice about preparing for a crash. I wrote an article “Stocks can crash even if the economy is growing”.