The Next Crisis

A Critique of the Article “Four Things That Could Go Wrong Now.” Wall Street Journal 10 Aug. 2015, R1. Print.

The Wall Street Journal, and other publications like Barron’s, periodically advises its readers to prepare for the next financial crisis. These articles are largely aimed towards the retail investor and can be found in the “Journal Report” or “Investing in Funds & ETFs” section of the Journal.

Where They Get it Right:

The Journal rightly brings to the reader’s attention the need to prepare for negative market events: The ability of the tech sector to bring down the market again; The Chinese stock market decline and the potential for failure of the Greek Bailout; Past and future missteps by the Federal Reserve and central bankers around the world; The inevitable bursting of the bond bubble (whose existence we can debate for hours another time…). The Wall Street Journal hits the nail on the head when it comes to the idea of being ready, being cautious, and safeguarding your portfolio from global financial upheavals.

Where They Get it Wrong:

First, let’s be honest. If you are young and have a long time horizon, time itself is the best safeguard. Not panicking through market downturns and dollar cost averaging over a lengthy career smooths volatility and lessens buy high sell low behavior. But time is not on all investors’ side and being proactive is important. Let’s look at some recent advice from the Wall Street Journal:

Risk: Overheated tech stocks come back down to earth.

WSJ Solution: Don’t over-allocate to the tech sector (okay, this is sound advice), buy long-term put contracts, and place stop-loss orders on tech stocks.

Our Take: Buying long-term puts can cost upwards of 2.5%, a hefty fee to protect against an event that isn’t a given. Puts, which give the holder the right, but not the obligation, to sell a security at a set price, appreciate if the underlying security depreciates in value. If the underlying security appreciates, the puts expire worthless.

With stop-loss orders a sell-decision is triggered by a loss of a pre-determined amount set by the investor. Selling a stock simply because it has declined in price may result in selling a good company just because it has a bad day, or worse, because the sector has a bad day. The decision to sell a stock should be based on the valuation of that stock, or because the long-term ability to keep competitors at bay, and margins high, has been eroded.

Risk: The Chinese stock market continues to decline and the Greek Bailout fails.

WSJ Solution: Buy call options on the volatility index known as the VIX and shorting ETFs that track large sectors of the Chinese economy.

Our Take: As with the put contracts, call options are not cheap and are difficult to understand for the average retail investor. As for betting against the Chinese stock market and economy, you will not be betting against a free-market economy. The Chinese government is working hard, even devaluing its currency, to fight the downfall. The saying goes “Don’t fight the Fed.” I’m guessing fighting the Chinese government could have similar, if not worse, consequences.

Risk: Central bankers make matters worse either through what they’ve already done or by raising rates too soon.

WSJ Solution: Buy long-term bonds and gold.

Our Take: While I’ll reserve discussion of gold for another conversation, buying long-term bonds as a hedge against the missteps of central bankers implies investors have a lot of time to let the bonds mature and aren’t likely to need access to liquidity. The Wall Street Journal correctly states that longer bonds react more to inflation expectations than to the whims and policies of central bankers…they also experience much wider swings in price and react to economic growth expectations. Long-term bonds are further out on the risk curve and should not be used as a bet against the Fed.

Risk: The Big Bond Selloff.

WSJ Solution: Avoid getting caught in a liquidity trap during a selloff by buying mortgages and, you guessed it, make more bearish bets in the form of put contracts on investments like high yield corporate bond ETFs. The idea is to shift into bonds that are less frequently found in funds and ETFs to limit exposure to a rush in selling and fund redemptions.

Our Take: The Journal alleges that mortgages are safer today than they were during the financial collapse. Even if this is true, due to higher lending standards, it takes due diligence to understand what makes up all the tranches of mortgage debt. Further, mortgage bonds can and often are called early due to the ability of homeowners to pre-pay, reducing the predictability of these securities.

Once again, options contracts can be expensive and are hard to understand for most investors. Also, to quote John Maynard Keynes, “Markets can stay irrational longer than you can remain solvent.” You may be convinced that the day of reckoning for high yield bonds is upon us, and buy put contract after put contract on a high-yield ETF, only to watch as the bonds increase in value for years while you watch expensive puts expire worthless.

Conclusion: The Wall Street Journal correctly points out that investors should be careful with their wealth today. However, major risk events have always existed with financial markets, with some coming to fruition and others passing by harmlessly. Rarely is there a good time to pursue an expensive and unpredictable investment strategy, particularly one that is challenging to understand. Investing is not easy but it can always be made more difficult. We take pride in our processes of due diligence to reduce volatility in our client portfolios and are always happy to discuss why we agree or disagree with various nuggets of investing “wisdom.”