Rebalance To Buffer Crises?

by: Emmet Kodesh

"People should be prepared for some very bad news, a dramatic decrease in the general stock markets. It will be 66% from the top to the bottom for the DOW." -- Ron Rosen (9-06-13)

The major asset classes reflect a great deal of what von Mises termed "interventionism" by the government. The distortions that have resulted are masked by mainstream talking points, but many investors see the "proof in the pudding" daily. Bond yields, and prices, have seesawed since May 22 when taper talk hit hard. The yield on the 10-year for three months has shown volatility like that which one expects in PM (precious metals) prices. September 5, the 10-year yield touched 3% before retreating to 2.94%. As a result, many people are selling down, or entirely exiting their bond holdings to protect their principal. How wise is this defensive strategy?

Real estate is tied to yields. Late July saw the largest plunge in new mortgage applications in five years since the "credit crunch" and crash: down 64.2% since May. New home sales also have been hurt. Last week was nearly as bad with the rise in the 10-year. Rates are low by historic measures and crazy for a long-term note in a depreciating currency. However, if it rises much more, the small housing recovery will collapse and so too will the markets.

As for holding equities, Doug Short recently examined the 142-year S&P (NYSEARCA:SPY) trend line and showed that a regression to the mean, inflation-adjusted rising trend would bring it to 998, a 41.6% decline from the 1709 high the first week of August. Few if any investors want to see that unless they have positioned themselves 80-100% in cash. Is that, then a prudent choice? Short also showed that even if the S&P were to descend to the average 40% above the trend line level of a bull market, it would take us to 1375-1400, the level of the November 15, 2012 trough, about a 20% correction off this year's QE-trussed highs.

Add to this context the jostling of the great powers over Syria (which actually may mask financial wrestling), increasing uncertainty about military action there, its consequences and the upcoming argument in Congress about the debt ceiling and there are many reasons to reduce or exit equities. Which option, reduce or exit, makes more sense?

Ironically, government intervention in markets makes a case for caution not only in being on the sidelines but in continuing to play, a bit. The major asset classes have been greatly affected and distorted by government monetary and legal-regulatory hyper-management. They are dangerously inflated but the various means of influence shows, as seen Friday, that yields again can fall and equities stagger back to level. Apropos of hedging through diverse asset classes: both Tuesday and Friday of the shortened Labor Day week (September 3-6) saw equities perform poorly while PMs outperformed. Last Friday, the junior Gold Miners (NYSEARCA:GDXJ) was the top-performing commodity and one of the best ETFs in the market, +2.86. Some will call it just another dead-cat bounce. Still, GDXJ is up nearly 25% since the June 26 low-since-inception. Even after a rocky week (volatility typifies the sector), silver (NYSEARCA:SLV) is up c. 28% since its late June bottom. Gold (NYSEARCA:GLD) has risen about 18% from its low at $114. So too has gold bullion. In contrast, the S&P is up about 4.6% since late June and has much further to fall than the PM sector.

If the news of China's renewed growth is accurate, that should help provide some footing for global commerce and markets. China's service PMI is 52.8 and the eurozone, some report, is "picking up." One also must not underestimate the ability of major states to finesse financial difficulties, manage narratives and otherwise give a positive direction to sticky-wicket economies. Therefore, I would not suggest going to 100% cash despite the possibility of major turmoil in the primary asset classes.

Many analysts, like Robert Fitzwilson and Michael Pento with abundant experience studying markets and managing money, expect major corrections of about 20%. Fitzwilson, head of the Portola Group even has said that "generations of norms and wealth will be destroyed" in the end game of the fiat experiment, now in its 42nd year since the abrogation of Bretton Woods. Pento expects inflation to accelerate as the economy's need for QE compels increased liquidity.

Differences in net worth and income stream makes a one-size-fits-all plan hard to present. Still, I believe one should not fully cash out of this market, either equities or bonds. A balance of 30-35% equities (including precious metals and miners), 10% bonds with the rest in cash will catch income and the possibility that the governing cadres at home and abroad will manage to limit the market stumbles and maintain forward momentum. One can add back, or exit entirely if and when policy clarifies or things begin slipping badly.

A point to consider is that sovereigns may save themselves at the expense of citizens. Poland has withdrawn $37 billion in government holdings from national pension funds to pay down sovereign debt. Its markets dropped 4.8% the day the news hit. Given relative GDP size, a similar take here would be north of $1 trillion and laws have been prepared to bail-in major banks. Many cities already are bankrupt and pension funds are at risk as pensioneers and bond holders battle over the remains. Those who buy the official narrative are riding in a ticker-tape parade on which Central Banks are showering confetti. When the dreamers awake, they will be looking at a demonic jack-o-lantern.

If policy remains chaotic and volatility and yields increase, as is quite possible, one can pare down most remaining equities and all bonds. It is the belief of many who are agnostic about assets that gold and silver will regain their status as a hedge against deterioration in other classes. This belief may be why the Pure Funds Diamond and Precious Gems ETF (NYSEARCA:GEMS) has performed strongly in recent weeks as crises swell. One also might consider one of its holdings, Dominion Diamond (NYSE:DDC) as an uncorrelated, store of value holding. The most profitable PM miners, First Majestic Silver (NYSE:AG), Endeavour Silver (NYSE:EXK) and McEwen Mining (NYSE:MUX) could be trimmed on a strong up day, but main holdings in these assets should be retained.

Yes, it's time to rebalance, reduce bonds and increase cash but, in my view, not yet to go to 100% cash. Let us hope for sanity in high places, moderation and, against all experience, less regulation and hyper-management, which guarantee impoverishment. Perhaps then we might have a soft landing from the power agendas of raison d'état.

Disclosure: I am long AG, GEMS. 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.