Remember the 1987 stock market crash? One week before the crash, a rift developed between the German finance minister and the US Treasury secretary over international policy coordination—to support the dollar and prevent US interest rates from rising.
While it isn’t clear whether this rift caused the crash, it certainly contributed to it, confirming the increasing importance of international policy in addressing global economic crises. But have policy makers leaned this lesson?
Judging from the outcome of the recent meeting between US Treasury Secretary Timothy Geithner and his EU counterparts over the handling of the sovereign debt crisis, the answer is no. The situation seems to be so severe that the two sides want to go in separate ways again. And that’s what raises the prospect of a 1987-style crash.
But what raises the prospect of a stock market Crash is monetary policy max-out in the developed world that has driven both short-term and long-term interest rates near zero, fueling all sorts of highly leveraged carry-trades that cast a big threat on Wall Street should a reversal in a major variable goes the wrong way (e.g. a big dollar appreciation against the euro). What should investors do?
1. Buy protection. Short or buy puts on SPDR S&P 500 (SPY). The problem, however, is that the S&P 500 had a correction already. So investors may want to average into this trade rather than going outright into a major position, and they may want to do the same with iPath S&P 500 VIX Short-Term Futures ETN (VXX).
2. Short currencies that have been benefiting from carry trade, the euro, the Australian dollar, and the Brazilian real: Market Vectors Double Short Euro ETN (DRR), short CurrencyShares Euro Trust (FXE), short Rydex CurrencyShares Australian (FXA), and iShares MSCI Brazil Index (EWZ).
3. Avoid or even short US cyclical stocks and precious metals that had a big run up on a weaker dollar. Caterpillar (CAT) and Walter Energy (WLT), which missed on second-quarter revenues by a great margin, is up 600 percent since 2009. Cliffs Natural Resources (CLF) is up 400 percent. iShares silver trust (SLV) is up 350 percent since early 2009; SPDR Gold Shares (GLD) is up 100 percent; and Freeport-McMoRan Copper and Gold (FCX) soared 400 percent. But the commodity rally may be over.
Disclosure: I am long DRR.
Additional disclosure: I may establish short positions on FXE and FXA.