Last week I was speaking to a very smart client, an individual who is technically capable and of not-easily-categorizable political and economic views. He asked me, “What if I am certain that event X will happen, and that it will precipitate a market crash? Why should I not go to cash now?”
Given the degree that the market has responded to events of various kinds over the last five years, and the range of potential events easily contemplated, it is certainly not a foolish question. Among the events on the table are an Israeli strike on Iran, the likelihood of another iteration of the eternal European debt crisis, an escalation of the tensions in Asia between China and Japan, a controversial outcome to the U. S. election, or a financial crisis in the United States precipitated by our out-of-control deficits.
With all this bad news, why not go to cash and wait for better times?
This first question answers itself. If times are ever genuinely and unequivocally better, the market will be higher. Selling now, waiting for higher prices, then buying back, is always an entirely foolish sequence.
So how about this client’s proposed strategy — sell now, wait for worse news and lower prices, and then buy back cheaper?
In theory, this would be advantageous. The difficulty comes in the intrinsic difficulty of accurately predicting events, and in the even greater difficulty of predicting sequence.
One of my general expectations of the market is that it will usually behave contrary to any strong consensus position. That was my belief at the depths of the market crash during the financial crisis. The lesson of history was that a catastrophic decline is usually followed by an explosive recovery. In early 2009, the consensus expectation was that it would take a decade, perhaps even two, for the market to recover. The reality is that less than four years after the market low, we have recovered most of our losses.
The possibility that is most heavily discounted today is that of an upside surprise, driven either by unexpected good news or by an unanticipated reaction to bad news. Imagine you go to cash now, expecting a market break, and instead the market rallies 30% on a Romney landslide, or an uptick in economic growth, or a quick and decisive victory over Iran. Do you re-enter the market, having missed that 30% uptick? What if good news is followed by bad news? Romney announces a return to the gold standard, or precipitates a trade war with China, and the market tanks? In this scenario, you miss a 30% uptick, participate in a 40% decline, and end up way worse off than if you just stayed the course. (Feel free to construct your own good news/bad news scenario about an Obama victory.)
Followers of this blog and our White Paper on the European debt crisis know that we are mightily concerned about the level of U. S. debt and deficits. We struggle to maintain our optimism despite despair over the failure of our two political parties to get serious about our budget woes. It is hard to believe a true currency crisis would not trigger a market break. We also have concerns about future inflation.
But we could be wrong across the board. Regardless of who wins, the election might be followed by a serious, comprehensive and bipartisan budget deal. Bernanke may draw to his inside straight, and gradually unwind the Fed’s bloated balance sheet while keeping inflation under control. Any time we insist on predicting, we risk being irrecoverably wrong.
There is an alternative. Without resorting to full market timing, we can hedge our bets. Instead of predicting, we can do lots of suspecting. We can apply a variety of hypothetical stress tests to our portfolios. What that process leads to, right now, is an overweight-equity position, implemented through a defensive-equity strategy focused on less-volatile, higher-quality companies. This combined with a bond portfolio of high quality and very short duration.
At some point in the next year or two, something big will happen. Prices will get out of whack. We’ll take advantage.