Escape Strategies For When The Stock Market Starts To Burn

by: Eric Parnell, CFA

It was one of the most infamous building fires in U.S. history. The date was November 28, 1942. The place was the Cocoanut Grove, arguably the finest nightclub in all of New England. Up until that fateful day, The Grove was the place to be seen and was frequented by sport stars, celebrities and power elites. It was also, however, a place with dubious ties and there was a tragic accident just waiting to happen. And so it did on the Saturday after Thanksgiving in 1942 when a fire rapidly engulfed the establishment in just 15 minutes, killing 492 guests and severely injuring another 166. The Cocoanut Grove fire resulted in important changes in building code fire safety as well as advancements in the treatment of burn victims. And over 70 years on, it also provides some important lessons about the strategies that should accompany investing in the stock market today.

It was only a matter of time before disaster struck the Cocoanut Grove. The popular nightclub was an expansive maze of dining rooms, bars and lounges that extended across several floors. As evidenced by its name, the atmosphere was a southern Pacific tropical theme complete with artificial palm trees, bamboo, rattan and draperies hanging from the walls and ceilings throughout the club. In short, it was filled with highly flammable materials. Making matters worse, the layout inside of the building was complex with relatively few exits from the club. And those exits that did exist were either obscured or blocked to prevent patrons from sneaking in or skipping out without paying their bills. Thus, when a fire suddenly broke out at 10:15 PM that fateful evening, many of the more than one thousand people in attendance, which was more than double the listed maximum capacity of the establishment, had little chance to escape.

Unfortunately, today's stock market shares several disconcerting similarities to the Cocoanut Grove.

First, the stock market is most popular with the powers that be in the investment world. It is the favorite of the U.S. Federal Reserve and other global central banks, which have gotten to the point where they now openly vocalize their want to see stock prices go up daily if not intra-daily. It is also the stomping ground of the institutional investors that are in receipt in one way or another of the daily liquidity injections from global central banks, as stock prices seem to elevate daily even if the fundamental economic and market backdrop suggests otherwise. Unfortunately, the average retail investor has been largely shut out from all of the excitement, as trading volumes remain light and many have simply chosen to steer clear of trouble and stay home instead. But with stocks rising to fresh new highs every single day regardless of the news, the stock market is an establishment that is looking increasingly crowded with cocksure institutional bulls roaming the market corridors.

Second, the stock market is an accident waiting to happen. It is no longer a secret at this point what is driving stock prices higher. It is not the global economy. It is not corporate revenues and earnings. It is not the outlook. Instead, it is the endless liquidity injections by global central banks. It has gotten to the point that this is the key theme of most investment discussions on business television and in the press today. A market riding high exclusively on one major theme is bad enough, but when this theme is dependent on the vagaries of human behavior and word choice by selected policy makers, it makes matters all the more tenuous.

Lastly and perhaps most importantly, once a fire is finally ignited in the stock market, it is likely to spread so quickly that it may prove difficult if not impossible to get out without sustaining severe financial injuries. Everyone is now keenly sensitive to the use of key words such as "tapering" that are likely to spark a panic in the halls of the stock market and send everyone rushing to the exits at the same exact time. After all, if a short tweet presented either through hacking or simply in jest, or a few off hand words from an on-air commentator can allegedly spark a sudden market sell-off on any given trading day, one can only imagine the market reaction when a legitimate cause for alarm finally presents itself. And the one thing that we know almost for certain even before any fire erupts is that the nanosecond high frequency trading computers will be the first ones out the door leaving everyone else trapped inside.

All of this leaves investors today with some difficult choices, which are outlined below:

Simply Stay Home

For those that are more concerned with the return of capital than the return on capital, this is an attractive choice. The only trouble is that the ability to earn a sufficiently high rate of return on FDIC insured bank CDs, high quality short-term bonds or any other relatively more secure options has been all but eliminated thanks to the relentless easy monetary policy and zero interest rates from the U.S. Federal Reserve. It is almost as if the shelves in the grocery store have been stripped bare and investors are being forced to the nightclubs for a decent meal whether they want to go or not. This fact in and of itself is unfortunate, for the profligate continue to be helped by current policy at the expense of the responsible.

Go To Another Establishment

This is also a reasonable option, but policy makers certainly do not view all markets in the same way that the stock market is adored. The commodities markets (NYSEARCA:DBC), including precious metals such as gold (NYSEARCA:GLD), silver (NYSEARCA:SLV), platinum (NYSEARCA:PPLT) and palladium (NYSEARCA:PALL), for example, is certainly anything but frothy at present and actually offers attractive value in many instances. But it remains on a bumpy path these last few months, and while one could only imagine the reaction from policy makers if someone or something was flagrantly taking stock futures sharply lower nearly every morning between 8AM and 8:30AM EST before the start of the trading day, so it has been for the metals these last few months. And while it is difficult to say exactly when a fire will finally ignite in the stock market, it is equally difficult to say exactly when the metals complex will capitulate and the recent downside pressure will finally abate. But for those with a long-term view, the recent decline in prices has presented what appears to be for many an attractive buying opportunity.

Instead, those that are not interested in the stock market are instead continuing to flock to the bond market. Unfortunately, the return servings in this area of the market have become skimpy at best and are accompanied by risks of their own that are increasing by the day. After all, when investors are receiving the same yield today on junk bonds (NYSEARCA:HYG) that they were receiving only a few years ago on U.S. Treasuries and FDIC insured bank CDs, these patrons may be in for some extremely unpleasant surprises once interest rates start to rise. With that being said, some attractive choices are still available here, including Build America Bonds (NYSEARCA:BAB) and Long-Term U.S. Treasuries (NYSEARCA:TLT), which remain among the best places to be if and when the stock market starts to burn.

Frequent The Stock Market And Carouse It Up

Knowing that the best action in town right now is in the stock market, perhaps it is just best to throw caution to the wind and fully allocate to the stock market. Maybe a fire will break out, but then again maybe it won't. And who wants to miss out on a great time, right? The only problem with this approach is the extreme risk. Yes, the market may not start to blaze for several more years if ever. Then again, it could be igniting as we speak. While many at the Cocoanut Grove were likely having the time of their lives at 10PM on Saturday, November 28, 1942, the party came to a tragic and terminal end only a few minutes later, as it spread so quickly that many were found still sitting in their chairs drinks in hand in the aftermath. Thus, while taking the full plunge into the stock market is certainly a tempting alternative, it is a treacherous path to say the least.

Visit The Stock Market, But Know Your Emergency Exits

Perhaps the best strategy is to include stocks among a number of establishments that you are visiting at any given point in time. The stock, bond and commodities markets all have their pros and cons, and while bond and commodities investors are certainly not the hot spots that stocks are today, they have each had their extended periods in the spotlight and usually offer a very different experience over time that helps provide you with a more consistent and well rounded experience in the end. And regardless of how heavily you are involved with the stock market, it is always important to know exactly where your emergency exits are at all times. This includes paying attention to technicals as well as fundamentals and maintaining a short-term view on the positions you own. This does not mean that you will not suffer some damage if a fire breaks out while you are in attendance, particularly since some of the exits may become unexpectedly blocked amid the panic just as they did at the Cocoanut Grove that fateful night. But if you are at the ready to evacuate the stock market when the time comes, you stand a much better chance of emerging relatively unscathed versus those that are fully libated and caught up in the roaring stock market party.

As for positioning oneself for such an emergency scenario in stocks while in attendance, an emphasis on higher quality names that trade with relatively less price volatility and also offer attractive valuations with strong technical support is the best way to be prepared. This includes top shelf names like Exxon Mobil (NYSE:XOM), International Business Machines (NYSE:IBM), General Electric (NYSE:GE), McDonald's (NYSE:MCD), Oracle (NASDAQ:ORCL), Emerson Electric (NYSE:EMR), Qualcomm (NASDAQ:QCOM) and Cisco Systems (NASDAQ:CSCO). While all of these names are unlikely to escape completely free of damage if the stock market were to ignite, they stand a much better chance of survival than their lower quality, high beta and momentum stock brethren. For example, during the 2007-2008 crash, stocks like McDonald's actually gained over this time period while names like Exxon Mobil and Oracle were down considerably less than the broader market and held up reasonably well until the very end.

Hopefully it never comes to the point where stocks are suddenly overrun with panic. But with the market as jam-packed as it is right now with investors riding on the same hope of boundless monetary stimulus from global central banks, it is unfortunately only a matter of time before the lighting of single match in the form of a rumor, a news report or perhaps seemingly nothing at all sets it fully ablaze. After all, investigators to this day are still uncertain as to what actually started the fire in the Cocoanut Grove, and this may ultimately prove the same in today's stock market in the end. But as long as the stock market is just one of the many market establishments you visit and you enter prepared with the right holdings and exit plan when the time comes, you can participate in the upside while still protecting against the potential downside if and when the time finally comes. And one can only hope that if a stock market fire does occur, that unlike recent past episodes that the appropriate safety standards will finally be implemented to help prevent yet another crisis a few more years down the road.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long CSCO, GE, XOM, MCD, IBM, QCOM, ORCL, EMR, TLT, BAB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long the precious metals via the Central GoldTrust (NYSEMKT:GTU), the Central Fund of Canada (NYSEMKT:CEF), the Sprott Physical Silver Trust (NYSEARCA:PSLV) and the Sprott Physical Platinum & Palladium Trust (NYSEARCA:SPPP).