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Summary

  • Over the weekend, Rupert Murdoch tweeted, "Stock market dive overdue, may have further to go".
  • Nasdaq slide portends shift to risk-off behavior.
  • The FOMC is trying to "take away the punch bowl". A hangover could ensue.
  • Gold can protect your portfolio against losses in risk assets and against monetary debasement.
  • The financial sector is facing a major test. Banks are seeing declining revenues as they prepare for a rising Federal Funds Rate.

When considering the recent swoon in stock markets, some context is essential.

The Capital Asset Pricing Model (CAPM), which is used extensively in the asset management industry, implies that the only risk an investor is rewarded for is the market-correlated risk. Under this model, specific risks can be diversified away entirely, thus, the market basket has the optimal risk-return proposition. The expected returns from any asset can therefore be written as a function of its market correlated risk. Under this model, the fundamental differences between assets are unimportant to individual investors, because the market is assumed to perform efficient risk analysis.

Since the 2008 crash, however, markets have been myopically focused on the Federal Reserve and not risk analysis. This is because of another feature of the CAPM model, the assumption of a theoretical "risk-free" rate. According to the CAPM, investors are rewarded for their exposure to market risk with a higher expected return than what they could get on the risk-free asset. In modern finance, Treasury Bills proxy for the risk-free rate. By driving down the returns on Treasury securities to zero, the Federal Reserve has been encouraging investors to buy risk assets in pursuit of return, causing a disconnect between price and value across asset classes.

This flood of liquidity has led to a historic "search for yield", with investors bidding up the prices of risk assets. Despite little improvement on systemic issues, the S&P 500, the FTSE, and the Dow Jones Index of US Corporate Bonds are all back above their 2008 peaks.

(click to enlarge)The reflation of S&P 500, FTSE, and US corporate bonds

(Source: Google Finance)

In a highly liquid environment, it is easy for investors to leverage up winning positions in order to increase their expected returns. In this way, the S&P 500 returned over 30% in 2013. According to the most recent data, February 2014 margin debt was the highest ever, at $465.72 billion. This situation is precarious.

Then the Bidding Stopped

(click to enlarge)Sotheby

Momentum stocks have seen the most pressure thus far. In the last month, Pandora (NYSE:P) is off over 30%. Sotheby's (NYSE:BID) is down 20%. Other top gainers like Tesla (NASDAQ:TSLA) and Amazon (NASDAQ:AMZN) are off over 15%.

The Nasdaq (NASDAQ:QQQ) exchange, which has a disproportionately large tech component, is particularly risky (P/E of 21.15, relative to 16.30 for DOW and 17.69 for S&P). Thus, under the CAPM model, its Beta, or market correlated return, is large (although I personally can't measure it). The recent weakness in the Nasdaq is an ominous sign. It led the charge into risk assets, with a 41% return in 2013. Without this leadership, other risk assets could see a long overdue change in direction. Because of the large debts in the financial sector and correlation across asset classes, selling could be self-reinforcing.

The financial sector is currently going through a major test of confidence. In many segments, including refinancing and trading, revenues are down. The possibility of a rising federal funds rate is in focus.

JPMorgan (NYSE:JPM) disappointed when it reported EPS of $1.28, a sharp decline from $1.59 in 2013. Analysts missed the direction of revenues, projecting growth only to find a slight decline.

Citigroup (NYSE:C), a troubled institution, recently saw its capital distribution plan rejected by the CCAR. On Monday, the company reported earnings that were well-received. Underlying the steady EPS of $1.23 reported were some worrying details. Total revenues fell 2.2% year-over-year. The CEO, Michael Corbat, mentioned that industry-wide bond trading revenues would fall ~10% this year. Finally, the adjusted loss at Citi Holdings, which holds troubled assets left over from the financial crisis, eased to $292 million from $798 million a year earlier. Whether this is the result of material improvement in the credit profile, or a simple change in provisioning practices is unclear.

Wells Fargo (NYSE:WFC), the biggest US bank by market cap, is providing some support. It reported strong earnings growth on Friday, increasing from $.92 per share in 2013 to $1.05 in 2014. Even it did not avoid a 3% slide in revenue.

Bank of America (NYSE:BAC) earnings will be on Wednesday. The company also had its capital distribution plan rejected by the CCAR last week.

Shorting financials could be profitable, but comes with significant risks. A fresh blast of liquidity would destroy your position.

Rupert Murdoch, owner of the WSJ and other influential news outlets, tweeted Saturday night saying, "Stock market dive overdue, may have further to go. Means fewer IPOs this year. Meanwhile Alibaba getting hassled by Chinese government."

Now, the selling is spreading as the FOMC takes away the punch bowl. The S&P 500 (NYSEARCA:SPY) is down 3% in April. In this environment, it can be hard to hold a portfolio of long-term investments without worrying about further paper losses. In a situation where liquidity remains sufficient, they will likely rebound, but if the financial system seizes up, losses could be large.

If you hold a small portfolio, particularly one with a high portfolio beta coefficient (one that goes up a lot on good days and down a lot on bad ones), it's time to begin protecting your portfolio from the Wile E. Coyote moment - when the market finds out it has no support.

SPDR Gold Trust (NYSEARCA:GLD) has very little correlation, and thus gives a large diversification benefit. Also, its value is stable. It's difficult and expensive to extract. Thus, there is a limited supply. Many factors lead to increasing demand for gold: population growth, geopolitical instability, financial instability, consumerism, inflation, and inequality, just to name a few.

In a shorter time frame, you may prefer to hold stocks because of the opportunity for higher returns. By taking a position in GLD, you can significantly reduce the degree to which your returns correlate with the market.

Another option would be to short-sell financials, anticipating that they will be the next to feel pressure. While also a form of hedging, this strategy would significantly scale up your risk in some situations. If the Federal Reserve begins raising interest rates sooner rather than later, as they alluded to during the March meeting, it would put a lot of pressure on financial stocks, and your short would do great. However, if the FOMC were to slow down the tapering process, or even begin more stimulative policy, your short position could get destroyed fast. Performing more complicated strategies using options can get costly and still carry wrong way risk.

One major disadvantage of this strategy is the loss of leverage. If you allocate 25% of your portfolio to gold, you have that much less to invest in risk assets. This is called opportunity cost.

What is the cost of forgoing opportunities in other assets?

Robert Shiller is well-known for predicting the dot-com and housing bubbles, and for other work on long-term market valuation. Using his Shiller adjusted market P/E, he projects an average annual return of 4% for stocks over the next 10 years. A 10-year Treasury note paid 2.63% yield on 4/11/2014. This is down 200 basis points since the start of April, and below the 4% projected return on stocks. Any way you slice it, expected returns in the market are low.

Since its inception, the SPDR Gold Trust ETF has returned 183.44%. This is a CAGR of 11% over nearly 10 years, higher than all US stock market indices.

In the current unstable and friction-filled financial system, all market correlated assets carry significant risk. It is time to prepare your portfolio for choppy waters now. GLD will outperform in periods of monetary expansion and hold its value well during panic. GLD is the perfect hedge for a market-exposed, growth-oriented portfolio.

Disclosure: I am long GLD. 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 short C.

Source: The Wile E. Coyote Moment Is Coming: Ways To Protect Yourself