This is a market for short people, like me. Ben Bernanke gave us the news everyone feared - that the Kool Aid was running out and by the middle of next year investors could not rely on the "Bernanke" Put to coin money in financial assets as they had been doing since the 2008 collapse. The United States government did not take advantage of the 5 years to put its house in order, and instead of bringing the country to where it had at least a chance of a primary surplus, budget talks stalled on the floor of Congress and in the Senate where partisan politics were of more importance than the health of the U.S. economy.
In the meantime, Government debt to GDP has grown from 64% in 2008 to over 100% today.
In parallel, with the extraordinary efforts by the Federal Reserve Bank to supply liquidity, money supply has soared to levels unprecedented in modern times.
The stock market had a field day, with the Dow Jones Industrial Average more than doubling since 2009.
In the same timeframe, bond traders had as much fun as equity investors as the yield on the 10-year T-bill fell to less than 2%.
While this party was going on, who was being hurt? Didn't it seem like everyone was a hero, no matter what investments they chose? Stocks went up. Bonds went up. And, more recently, house prices have gone up. Are there any losers?
You bet. Savers were taken to the woodshed and severely beaten, so that those on fixed incomes saw their monthly interest fall dramatically. A major transfer of wealth took place, from those savers to those with the savvy and means to invest. Don't be surprised if you were not among them - you had a lot of company. What is interesting to a Canadian observer is that the world's largest free market, the United States, was far from "free" but was being manipulated by the central bank on a theory that monetary policy had something to do with asset prices, employment and economic growth. Of course it does, but a monetary policy that is based on simply buying assets soon finds out that it is not altering the mood of the market, it has become the market.
The result made Bernie Madoff's Ponzi scheme look like a walk in the park. Every dime of interest the Government paid on its national debt was paid from the sale of more debt, not to mention everything else the Government spent money on that exceeded its revenues.
Now Mr. Bernanke has declared that the economy is showing sufficient strength that it is possible to "ease off on the accelerator pedal" and engineer some soft withdrawal of the $85 billion a month of bond and mortgage backed security purchases sometime this fall and into next year when, if all goes according to plan, they will end.
Investors don't seem to want to cooperate, and have started bailing out of stocks and bonds hand over fist. You can't blame them. Madoff did not sell too many more units of whatever he called his funds after he was exposed as a fraud. Perhaps investors see the problem which, simply stated, is if the Government is going to continue to fund itself by issuing bonds and the Fed is not going to buy them, who is? Oops! Maybe no one!
The saddest and quietest time on a trading floor is when there are no bids. Today we have computerized that experience but no one has yet turned it into a video game for us and I miss the shouting, the torn up tickets and the tears.
As soft pedaled as Mr. Bernanke tried to make the subject in his speech, the fact is that so called QE is coming to an end and investors don't want to stand in front of the deluge of bond selling that will follow with $85 billion a month less demand. Interest rates will rise - they have already started that journey - and financial assets will fall in value.
Some players will benefit. Banks will enjoy the steeper yield curve and Life Insurance Companies will start to discount future liabilities at a higher discount rate forcing down the present value of those liabilities and reporting growth in earnings without having to sell more insurance or raise premiums.
Others will not have as much fun. Balance sheets full of long bonds (like those of many of the largest companies like Apple (AAPL) as pointed out by SA author Steven Rosenman) will have mark to market losses quarter after quarter, and will develop some form of "adjusted earnings" to explain the losses as if they were "non-recurring". I am sure they can get some help from Salesforce.com who have made "non-GAAP" and "adjusted earnings" such an art form they add back management compensation to calculate how much they make for shareholders, well described in a recent SA article by YCharts. If they could, they would probably add back cost of goods sold, rent, purchased services and freight. For my money, they might as well just report revenues because everything below the revenue line is someone's adjustment for the time being.
But, I digress. Where do investors go when the markets sour? Here is my plan.
- Keep a large cash position - at least 20% or more;
- Keep a short book at least equal in size to your long book - either by shorting stocks or by buying puts. Good shorts might include Whirlpool (WHR), Salesforce.com (CRM), ARM Holdings (ARMH), Canadian Pacific Railway (CP) and the long bond ETF through purchase of puts. Don't short illiquid stocks, just those where there is enough volume that you can cover easily without moving the market. Puts protect you from a short squeeze but you have to get the timing right;
- Take advantage of the lower prices to add to positions in long-term profitable growing companies with clean balance sheets and sensible dividends, like Microsoft (MSFT) and Intel (INTC). Treat your additions like fine wines - add slowly in small sips and savor the moment. And don't expect instant gratification. It will be a while before the "new normal" returns to the "normal" those of us over 40 (I am way over 40) are more familiar with.
- Take small positions in the really out-of-favor stocks - base metals, natural gas, some of the better gold stocks. Add slowly over a year or two until there is a definite trend to growth in demand.
Additional disclosure: I am either short through a direct short or through ownership of puts. I am long BBRY and INTC, numerous oil & gas companies, a number of mines and, of course, have a sizeable cash position.