So far August has been fantastic. Yet, if recent stock market history has taught us anything, it is that we should be financially prepared in the event of a stock market crash. With fear being near record lows, now is the time to ensure we are not complacent by focusing on risk management strategies. Thus, protecting the profits we have accumulated in 2012.
The S&P 500 Index rose 1.07 percent last week, marking the 5th consecutive week of gains. This was punctuated by six straight days of gains allowing it to close above the psychologically important 1,400 level of 1405.87. The S&P 500 is now less than 1 percent away from the highs reached in April and is at a key technical resistance level. Volatility remains low with the CBOE VIX (a sentiment index which measures investor’s fear) falling below 15, at one point Friday afternoon, its lowest level since March. An upward trajectory has occurred despite a less than impressive second quarter earnings season. Thus far, U.S. companies have reported the slowest earnings growth in any quarter since 2009.
SO FAR THERE HAS BEEN NO SIGN OF A MARKET CRASH, IN SPITE OF…
- A very low fear level, relative to the past 12 months, despite considerable uncertainty;
- Bond yields in the U.S. are at record lows, while several European sovereigns face prohibitive borrowing costs;
- Central banks continuing to employ radical policy tools to stimulate growth and support the financial system, while the International Monetary Fund has cut its estimates for global growth; and
- European countries being caught between competing policy goals of austerity and growth, while the developing world in general, and China in particular, try to navigate (or influence) a mild—rather than harsh—economic slowdown.
Historically, since August 1, 2012, the market has been fantastic as the benchmark S&P 500 is up 2.2%, thus far, pacing it to be the 3rd best August in 10 years.
THINGS THAT HAPPENED IN 2012 THAT MAKE THIS AUGUST DIFFERENT
There have been several catalysts which markets have either had a very positive response to, or if perceived as bad news—a surprisingly muted response to— that may have contributed to the present investor optimism:
- The U.S. Federal Reserve Board (Fed) extends Operation Twist, in which it sells shorter-term U.S. Treasuries and buys longer-term U.S. Treasuries, through the end of the year;
- The U.S. Supreme Court surprises many by upholding the “Obamacare” mandate;
- The pro-bailout New Democracy party wins the second Greece vote as “Grexit” is debated;
- Socialist Hollande is elected as the new French president;
- The European Union (EU) summit offers preliminary measures for reducing the debt crisis;
- Egypt elects Morsi as their new president, the Arab world’s first Islamist president;
- Moody’s downgrades 15 of the world’s major banks with no adverse stock market reaction;
- China cuts interest rates for the first time since 2008 based upon growth worries;
- U.S. mortgage rates reach a new record low (3.87%);
- U.S. manufacturing contracts for first time in nearly three years;
- The Dow Jones Industrial Average’s dividend yield reaches a record high spread versus the 10-year U.S. Treasury yield;
- The S&P 500 Index has its best June since 1997;
- U.S. crude oil inventory reaches a 22-year high;
- U.S. retail gas prices have the lowest May-to-June drop (–9%) in at least 30 years;
- The 10-year U.S. Treasury yield hits a record low (1.46%);
- Spain’s 10-year bond yield breaches 7%;
- The U.S. dollar nears a two-year high versus the euro;
- There is a record quarterly gain for the U.S. dollar vs. the yuan.
WHAT HAPPENS PRIOR TO A MARKET CRASH?
Typically, there are three causes for market crashes –
- Market Shocks- These are events which increase fear into the market overnight and are unpredictable. Examples include the Japanese earthquake and tsunami in March 2011, the down-grade of U.S. credit in August 2011, the gulf-disaster in April 2010, and the Lehman collapse in September 2008. These events seem to occur with some regularity, and thus we should prepare for them accordingly.
- Systemic Risk – These risks occur as ‘gradual breakdowns’ and are typically the ‘leaking pipes and hoses’ of the economy. They are issues that show signs of possible trouble, but have not reached their full impact. While the Lehman collapse was a market shock (the full impact), its underlying cause was the growing housing and credit ‘bubble’ (the gradual breakdown), which resulted in the systemic risk that sent the global economy into a recession.
- Recessionary Downturn – These are periods when several factors occur at the same time. They tend to gradually drain consumers’ and investors’ wallets and confidence. Thus, a recessionary downturn sends stock prices south quickly, persistently, and for extended periods of time.
WHAT’S AHEAD THAT COULD CAUSE A MARKET CRASH?
The key to getting through the next two weeks without a market crash will be determined via four economic reports. Poor reports in any or all of the four indices can potentially lead to a market crash. In addition, these numbers will also highlight the negative implications which are taking place as a result of central bankers recently “passing” on further easing last week.
- July U.S. Producer Price Index: Tuesday August 14, 8:30 AM EST. The producer price index in June edged up 0.1 percent, following a sharp 1.0 percent plunge the prior month. The core PPI rose 0.2 percent following a 0.2 percent gain in May. The consensus for Tuesday’s report is 0.2%. A reported number below -0.2 could potentially cause a stock market crash.
- July U.S. Retail Sales: Tuesday August 14, 8:30 AM EST. Retail sales in June were much softer than expected. These numbers included auto sales, which contradicted manufacturers’ numbers for the month. Retail sales in June fell 0.5 percent, following a 0.2 percent decrease in May. The consensus for Tuesday’s report is growth of 0.3%. A negative number could potentially lead to a stock market crash.
- July U.S. Consumer Price Index: Wednesday August, 15 8:30 AM EST. The consumer price index was unchanged in June after falling 0.3 percent in May. Excluding food and energy, the CPI rose 0.2 percent, following a 0.2 percent increase in May. The consensus for Wednesday’s report is growth of 0.2%. As with July retail sales, a negative number could potentially lead to a stock market crash.
- August U.S. Housing Market Index: Wednesday August 15, 10:00 AM EST. NAHB (National Association of Housing Bureau) housing market index surged 6 points in July to 35. The monthly gain was the largest in nearly 10 years. Additionally, the level of increase has been moving higher all year and is currently at its highest point of the recovery (since March 2007. The consensus for Wednesday’s report is again 35. A reading of 33 or below could potentially lead to a stock market crash.
HOW CONSERVATIVE (RISK AVERSE) INVESTORS CAN BUCKLE UP BEFORE AN AUGUST STOCK MARKET CRASH
Limit your risk with a Stop loss
There are conditions when neither direct, nor indirect hedges reduce risk sufficiently. When equity-market risk is too high relative to its short-term return potential that it is prudent to reduce equity exposure, the ISA stop-loss program effectively eliminates downside risk. This approach sets a maximum downside limit on holdings and sells when that threshold is crossed.
A stop loss program will determine the maximum loss-tolerance for the investor and automatically sell holdings to prevent such a loss. The stop loss program also implements a ‘trailing-stop’ approach which will ‘protect’ gains by selling holdings if markets begin to retreat from recent advances. The value of the trailing stop program is that the investor can benefit from gains when markets rise and retain those gains if the uptrend ceases or reverses.
HOW BALANCED (MIDDLE OF THE ROAD) INVESTORS CAN BUCKLE UP BEFORE AN AUGUST STOCK MARKET CRASH
Rebalance to safer asset classes now
Rebuild your equity portfolio with low volatility equity funds. Over long periods, low volatility equities have produced both a higher total return and lower volatility (better risk adjusted return and higher absolute return) than broad indexes. This is referred to as the “low volatility anomaly”, because it is contrary to the long held view that more return only comes from taking more risk.
As a generality, low volatility tends to lag in rising markets (captures less of the upside move), but to lead in falling markets (captures less of the downside move). Over cycles, low volatility has come out ahead.
HOW GROWTH ORIENTED (AGGRESSIVE) INVESTORS CAN BUCKLE UP BEFORE AN AUGUST STOCK MARKET CRASH
Apply long/short strategies
In our opinion, there have never been so many disruptive forces at work in the world which impact financial markets as there are today. In the current situation we are facing, utilizing the long/short strategy allows us to seek opportunities where weak markets can be exploited in order to yield uncorrelated returns with below market volatility. The investment manager will identify inversely correlated securities to purchase in the event of a downturn and seek gains to offset losses. The manager may also employ leverage to earn excess gains above losses.
To protect against extreme events, ISA may choose to add an extra layer of protection and actively hedge client portfolios by buying protection against spikes in volatility with index options or index futures. Since volatilities are priced almost uniformly across asset classes, the risk in a portfolio can often be reduced by taking a derivative position in a different asset class.
WHAT IF THERE IS NO MARKET CRASH?
The tactical approaches above do not hurt your portfolio performance if markets continue to rise, but they will protect you in the event of a market crash (which there will inevitably be). Much like the seat-belt in your car, it only takes a moment of your time to put on protection for your portfolio. A stop/loss, rebalance, or long-short approach can be built for your portfolio in less than 48 hours, following a complimentary 2nd opinion from our research team. To learn more about protection strategies for your portfolio please check my availability for a telephone appointment.