Investment Forecast: Cloudy with chance of default and variable recession. Trying to read the tea leaves and make prudent investment decisions for clients – or yourself – has been complicated by the headwinds out of Washington lately. The debt ceiling crisis exposes investors to a real risk of loss.
Crystal Ball Predictions
Depending on how you read your crystal ball, any and all of the following could occur with a government default:
- Higher short-term and long-term interest rates, not only for U.S. debt obligations but also for mortgages and consumer loans;
- A declining dollar, potentially leading not only to inflation but also to renewed concerns about its status as the world’s reserve currency;
- Liquidity issues and forced sales of Treasuries sparked by fear-induced withdrawals from money-market funds and a lack of viable “safe-haven” investments;
- Declines in the global equity markets – and ultimately your 401(k);
- An uncoordinated reduction in U.S. fiscal spending; and
- Consequent setbacks to the global recovery, potentially leading to another global recession.
Have a Plan
But clients are often calling me to find out what my crystal ball shows and what they should do about the future. Invariably, my response tends to be the same: Have a plan and work the plan. If you’re at sea on a cruise ship, you’d feel more comfortable if there was a plan in place before the boat runs into that iceberg or there was a fire, yes? Investing should be no different. Know where your exits are and how to get there.
Everyone’s needs and time frames will be different. If you have a plan in place, you’re more likely to avoid making big moves that can ultimately hurt you in the long-run. Ah, but there’s the rub! What’s the long-run? As economist John Maynard Keynes would say “In the long run, we’re all dead.”
Sure if you have forty years to retirement, you’ll have time to recover from this near-term foolishness. But what if you’re retired or nearing retirement? It’s harder to say simply “stay the course.”
As important as diversification is to reducing risk, the reality is that we all try to avoid pain and it certainly is painful to watch your savings evaporate because of things way beyond your own control. And it’s even more difficult to imagine when it may happen so needlessly. After all it’s not because the US Treasury has no cash flow or not enough money to pay it’s day-to-day bills. It’s not because investors have stopped buying our debt and making it possible for us to operate in the lifestyle we’ve grown accustomed to.
So what’s an investor to do? A prudent investor should consider options to controlling risks. These may include the following options:
- Shorten the duration of bond portfolios – we recommend less than 4 and closer to 2;
- Increase exposure to unconstrained bond strategies – go anywhere investment managers like Dan Fuss of Nataxis or Gross of PIMCO are good at this;
- Making allocations to international government bonds – in crisis folks tend to buy US Treasuries but if we’re in crisis the flows will go somewhere else;
- Incorporating an allocation to non-traditional investments that are less correlated to the equity markets – like ‘managed futures’ or Master Limited Partnerships for instance; and
- Raising cash to be prepared to cover short- and near- term obligations.
If you invest in a diversified portfolio like one of our MarketFlex models, then these options have been considered as part of the overall strategic allocation. But there’s more that an investor can consider as well.
Tactical May Be Practical
The only sure thing is that there’s nothing certain in this world. And everyone certainly has an opinion on what to do.
That being said, I’d say to clients that there are few things you may be able to do (certainly at this late hour with the ‘end of the world as we know it’ staring at us).
But this is why we recommend that clients build portfolios that capture the benefits of long-term strategic asset allocation – lots of eggs in different baskets – and also consider the proven advantages of tactical management. I would never recommend abandoning the important risk control benefits of diversification. But having been in this side of the business for more than 15 years (and in mortgage banking for about 14 before that), I know that there are times when it just doesn’t make sense to ‘fight the tape.’
This is the essence of using targeted tactical strategies. These are mostly based on momentum and trends or cycles. Just as there are cycles in nature, there are cycles that affect investing. When it comes down to it, investing is done by humans and we are almost all ruled by our emotions. We are ruled by fear and greed. Each of these emotions can have an outsized impact on the basic supply and demand for a particular investment whether a stock, bond or currency. So if you can read the price and volume momentum (the basic supply and demand) of any particular investment, you can position yourself to ‘go with the flow’ or switch to cash or some other investment.
Investing and Physics
My toddlers know that I constantly tell them that “physics is the answer to all things.” It can explain almost anything in nature. And not surprisingly, I can show how investing is like physics. When it comes to the price momentum of any stock, you can simply modify the rule about a body in motion. In this case, a stock that’s going up will tend to keep going up until something stops it. And on the other side, a stock price that’s going down will tend to keep moving down until the forces in the market change.
It’s not perfect, true. And your read of these tea leaves may be wrong. But sometimes it makes sense to not simply avoid putting all your eggs in one basket but also guarding the basket. Tactical strategies are designed to help mitigate the risk. If we can avoid most of the downdrafts, we won’t have that far to climb back up to get to breakeven. And this just makes sense for those concerned about their 401(k) or other retirement savings.
This just reinforces the first rule of investing: Don’t lose money. You’re sure to win if you can do just that.