If Bear Market Rally Unfolds, Diversify Risk

By Eric Roseman

The wrong way to invest in a secular bear market is to lunge after stocks, even at these multi-year lows. We're still mired in a severe credit-inflicted recession that will probably keep a lid on growth for the next few years until leverage in the financial system is finally exhausted.

However, concerted global government spending - unprecedented in the post WW II era - implies at least a few quarters of positive GDP growth in the United States and overseas in 2010. That's exactly what transpired in the mid-1930s following FDR's first New Deal.

The right way to reduce risk is to build an equity position gradually over the next several months while also adding inflation-based assets, which should also rally along with the stock market as inflation concerns rise. Treasury bonds should be avoided, or sold short while investment grade debt (non-financials) and TIPs should be purchased.

An extended or multi-month stock market rally - long overdue even in the context of a bear market - should be accompanied by a lower dollar and rising Treasury bond yields as risk-averse investors dump safe assets in return for greater risk. This supposes that distressed hard assets like commodities, including oil, should rally in conjunction with equities as the dollar declines in any marked advance for stocks. This scenario also favors gold as investor expectations of renewed inflation drives investors out of the dollar.

I've started to buy stocks again for the first time since the advent of the credit crisis 19 months ago.

My strategy is to scale-in very gradually or dollar-cost-average into global markets while also buying commodities, gold and TIPS or Treasury Inflation-Protected Securities. To reduce my equity risk in an environment of intense volatility, I've also purchased non-financial convertible bonds, which yield about 7%.

Foreign currencies, which have largely crashed against the dollar since last July, also look like strong speculations in this bear market rally. Resource currencies like the Australian, New Zealand and Canadian dollar are attractive while in Europe I like the Norwegian krone - heavily tied to the oil cycle. The Brazilian real, which has declined much less than other global currencies recently, is also poised to recover sharply.

The United States is desperate to grow her exports again. While other countries are now benefiting from cheap currencies after crashing versus the dollar since last summer, the greenback is next in line to decline once risk returns to the market. The Fed is so busy flooding the financial system with credit that it's almost a given the dollar will resume its bear market, which began in 2001.

Currency chaos remains a central theme in this environment and a lower dollar would be bullish for U.S. capital markets provided the decline was orderly. It would also spark the much awaited close above US$1,033 for gold. The above scenario is likely to emerge sometime in 2009.

The major caveat in this bear market rally remains credit, which is still largely fractured and recently started breaking down again in February as credit spreads widen accompanied by higher LIBOR rates since January.

Despite my concerns in the credit market, stock and commodity values have crashed by more than 50% and at these bombed-out levels should now be gradually accumulated over the next 6-12 months.

Comments

[Conan the B...:]

Two questions: When did the Secular Bear Market begin?

What is the Longest period of time, within a Secular Bear, before a Cyclical Bull has begun?

Cyclical Bull markets Do Not end within Months.

Mar 13 06:17 AM

[Cesato:]

I agree with paulaut, did we not hear the same argument when Dow hit 7500 last year? Nobody has a workable crystal ball at the moment. If the article suggests a buy, hold, get off breakeven on a reversal and wait, then agressive investors could try the bull instance considering than being cash is not giving us any return anyway but this kind of calls are somewhat irresponsible. Let's see what the earnings season brings us, although there are very attractive bargains out there the crisis has not hit a credible bottom yet nor will it anytime soon. Do you see why people are still extremely bullish in Gold and Silver?

Mar 13 07:25 AM

[Andy1234:]

I am not sure how to view the deflation/inflation argument for the short term.

Most of the money created to get inflation is lending by the banks.....and money being pulled from home equity....and house prices increasing.......which opens up more lending...etc.

I just don't see house prices increasing anytime soon....in fact....I see more declines ahead (Alt-A and option ARM resets)......so I understand the government is printing money like crazy.....but the banks are lending. And the only way that money gets to the public is through loans....correct? So if they aren't loaning....the money just sits there. I am split on the deflation/inflation call on the short term.....definitely have inflation long term.

Mar 13 08:20 AM

[GoldMarketPaul:]

"So if they aren't loaning....the money just sits there. I am split on the deflation/inflation call on the short term.....definitely have inflation long term."

Here in Japan the gov't injected a whole lot of money into the economy but it hasn't entered the system, years and years later. People are just sitting on heaps of cash for safety, so there's still deflation after all these years.

But I'm not sure Americans scare quite as easily as Japanese so I think there will be inflation sooner than later with people willing to let their dollars circulate.

Mar 13 09:19 AM

[kelm:]

I agree with a number of your investment points (currencies, commodities etc) but the core of your philosophy seems based on getting back into US equities which have now been shown to under perform the 30 year Treasury since 1969. I would argue that US stocks are fundamentally impaired an the equity focus should thus be on the markets where growth will be strongest over the next decade or so. China is likely though I personally want to wait til the current bear rally is over before venturing in there.

Mar 13 09:26 AM

[roguespeare:]

Every portfolio should have at least 10% in TIPS. While most would say that we're currently in a deflationary cycle, this will turn on a dime when the currency press starts working overtime (and that would be about now). I agree that investment grade bonds should be accumulated in something like Vanguard's short term bond fund VIPSX. As for stocks, Katie bar the door, Dow 7500 at best this year.

Mar 13 09:27 AM

[Cesato:]

You are right, the money hasn't hit the market yet but it's there in Governments' vaults. GoldMarketPaul made a point regarding Japan but the USA does not have a short term memory. As soon as the money hits the market and people feel good, not because they are back where they were before but because they will not be as bad as they are now, consumption will irresponsibly resume, as usual. Add supply destruction to the equation plus increase in Money Supply and you have the perfect scenario for inflation. If you are in precious metals don't wait for the first sign of inflation (probably months away)otherwise it will be too late, remember that Gold in particular is a leading indicator, however don't fall in love with your physical holdings, in real life anything may happen.

On Mar 13 08:20 AM Andy1234 wrote:

> I am not sure how to view the deflation/inflation argument for the
> short term.
>
> Most of the money created to get inflation is lending by the banks.....and
> money being pulled from home equity....and house prices increasing.......which
> opens up more lending...etc.
>
> I just don't see house prices increasing anytime soon....in fact....I
> see more declines ahead (Alt-A and option ARM resets)......so I understand
> the government is printing money like crazy.....but the banks are
> lending. And the only way that money gets to the public is through
> loans....correct? So if they aren't loaning....the money just sits
> there. I am split on the deflation/inflation call on the short term.....definitely
> have inflation long term.

Mar 13 12:23 PM

[Conan the B...:]

TIPS? If TIPS are to be your Inflation fighting vehicle of choice because that is the Point for its purchase, then there are many, many more investments which will provide a greater rate of return.

Almost everything Gold/Silver related will do better than TIPS.

Mar 13 01:31 PM

[yellowhoard:]

Got to agree with Paul on TIPS. You buy TIPS and you get to pay taxes on an inflation rate that the government lowballs.

So, when everything that you need to live on doubles in price, the government will explain that inflation is not bad because Intel has a new chip that is twice as powerful as the last one and only slighlty more expensive.

Mar 13 02:33 PM

[Mayascribe:]

Banks, batteries and bullion. By the end of the year all stocks in these sectors will be much, much higher.

Mar 13 03:39 PM

[Mayascribe:]

The above comment is my "TIPS."

For those who don't follow the energy storage sector, Exide (XIDE) dropped over 35% last week, and though it has gone back up some, it's still a steal @ $2.40/share, with a very limited downside. The huge drop was likely due to the hedge fund Tontine redemption.

It was a lot of fun to drop a few of my most recent gold mining stock purchases to buy bank stocks last Friday and Monday, and then dump most bank stocks today for about a 16% gain. 16% more I now have to slip into some junior gold stocks I've been eyeing such as Pediment Exploration, LTD. (PEZFF.PK), Vista Gold Corp., (VGZ), and New Gold and Western Goldfields (WGW).

Mar 13 03:52 PM

[Conan the B...:]

Maya: any thoughts on AEM.

heard they may be able to quadruple Gold output over the next 3 years.

Mar 13 11:29 PM

[Ad Orientem:]

I like GDL SLV and AEM. For some diversification to cover all your bases (diversification remains an imperative) I like PRPFX. To be honest PRPFX could almost stand on its own right now.

Mar 14 12:29 AM

[bearfund:]

roguespeare - Everyone should have 10% in TIPS? Wow. Not even in Geithner's wet dreams are investors that gullible. There is exactly one situation in which I would prefer TIPS to gold: Ron Paul gets elected president. Probability of that happening: significantly less than 1%, and even then you'll have 3 years plus to buy in. In reality the vast majority of TIPS are owned by institutional investors and financial companies who use them to hedge out CPI-based liabilities or pair them with opposing positions in ordinary Treasuries for spread trades. Only idiots actually buy them with the real proceeds of a hard day's work.

The "inflation" (actually the CPI accretion) component of TIPS values is taxed. Worse yet, it's taxed when it accretes, not when you sell or receive payment at maturity. You also must pay taxes in the interest you receive - not that there's really any of that these days anyway. Therefore even if you believe that the CPI accurately reflects YOUR cost of living, or YOUR cost of living at the time in the future when you will need the money you are investing today, TIPS are a guaranteed way to lose purchasing power if held in any taxable account. The only way to avoid this is to hold them in a Roth account; however, the tax advantages of these accounts can also be revoked on a whim by Congress. Moreover, you can also hold gold in a Roth account, and you may achieve even greater tax savings than you would have on TIPS, since all capital gains on gold relative to the dollar are taxes at 28%.

The truth is that the CPI grossly understates the true growth in the cost of living for virtually all American residents, and absolute yields on all forms of Treasury debt are currently at extreme bubble levels. There is absolutely no good reason to hold Treasury debt of any kind at these prices, including TIPS, even in tax-advantaged accounts. Prices of daily necessities have been rising rapidly for many years and are continuing to rise even in the face of deleveraging, asset-price crashes, and a steep decline in global output and demand. This trend will neither stop nor reverse at any time in the foreseeable future, and will very likely accelerate as central banks flood the world with more currency. Your only hope of beating this wealth destruction and the taxes the governments levy on both income and inflation is to employ leverage by shorting Treasuries and combining this position with a healthy long position in gold and silver.

With a little bit of luck and some talent for paying no more taxes than absolutely necessary you may find that this strategy allows the purchasing power of your net assets to remain relatively constant over time. You simply cannot say that about TIPS without asserting either that your effective tax rate is and will remain zero or that the CPI substantially understates the rate at which your cost of living is rising. I'd love to see you defend either of those assertions in print.

Mar 14 09:01 PM