What about Financial Crises?
During a serious financial crisis, many types of companies will suffer, but others may prosper. At the same time, some countries will prosper while others suffer. This is why you cannot exclude investing in stocks in many types of financial crises. There are opportunities to profit regardless of the situation. That’s why Mad Money’s Jim Cramer says, “There’s always a bull market somewhere.” He adds, “It might mean that you may have to look further and harder than your time and your inclination allow. That’s OK, too. What matters is that you don’t simply default to what’s in bear mode because you are time-constrained or intellectually lazy. . . . For 25 years there has always been a sector that works. You just have to find it.”2
There is an important caveat, however. Stock market opportunities are wide and diverse, but when a crisis hits, all stocks tend to drop together, regardless of industry or country of origin. This is what is known as a spike in correlation. Why? Alan Greenspan once described a stock market bubble as the result of “irrational exuberance.” John Maynard Keynes, for all of his mistakes about the benefits of government spending, was right when he said that “animal spirits” help control markets. When people panic, they sell first and ask questions later. Even investments destined to do well in a crisis are often sold indiscriminately. Panic selling can be the result of emotions or investors’ desperate need for cash.
In a crisis, buyers tend to pull back from buying even what they want to own. So prices fall across the board, punishing the good and bad alike. The indiscriminate drop in stock prices is short lived, however, and once things stabilize, prices begin to reflect opportunity once again. So in the short run, all stocks may seem to act in unison. A century ago both the buggy-whip maker and the automobile developer would have fallen in a panic. But the automobile maker nevertheless had a brighter future, which eventually would be reflected in its share price.
Passive Investing versus Active Investing
Before making a decision about the stock market, it’s worthwhile to investigate the different classes of assets subsumed under the broader term “stock market.” Now, there are many different ways of investing in stocks. You can buy a fund that mirrors a market index. The fund rises and falls with the overall market. This is known as passive investing or index investing. It is a low-cost strategy to match the performance of the overall market. You can buy shares of index funds to mimic the Dow Jones or the New York Stock Exchange. The only reason to do this is if you think the economy overall is going to rise, but you don’t know anything about the particular companies constituting the index. This is a passive investment strategy.
A passive investor can also select individual sectors or geographies using exchange-traded funds (ETFs). Sector ETFs are great for diversification—they allow you to buy an entire swath of the economy rather than picking a single stock. If you buy a telecommunications ETF, for example, you’re not betting on Verizon or AT&T—you’re betting on them and all their competitors. In some ways, it’s easier to spot profit opportunities in sector ETFs, since all you need to do is see the broad trends in the economy. Sector ETFs are narrower than buying an ETF for the entire S&P 500, for example. Sector ETFs aren’t all upside, however—they can be more expensive and more volatile than broader ETFs.
Here’s how sector ETFs work. There are two classification systems: the Global Industry Classification Standard (GICS) and the Industry Classification Benchmark (ICB). GICS has ten sectors, which include twenty-four industry groups and sixty-seven industries. The ICB has ten industries and thirty-nine sectors. In the end, they are quite similar.
So how do you pick a sector ETF? You can choose between market-weight sector ETFs, equal-weight sector ETFs, fundamentally weighted sector ETFs, and leveraged sector ETFs. Market-weight sector ETFs are focused on what are called “large cap” stocks—companies with market capitalization of over $10 billion. Equal-weight sector ETFs give equal weight to all companies in a sector, no matter the size. Fundamentally weighted sector ETFs are more sophisticated, selecting companies on the basis of certain fundamental measures of their health. Leveraged sector ETFs multiply gains and losses because they are based on borrowing and selling options and futures contracts.3
Studies have shown that sector ETFs can be a reasonable way to manage risk. If you don’t like risk, you might pick a utilities ETF; if you want a more volatile sector, you might go toward technology. Here’s a recent breakdown of the stock market by sectors: utilities (3 percent), telecommunication services (3 percent), information technology (18 percent), financial (16 percent), industrial (12 percent), energy (12 percent), healthcare (12 percent), consumer discretionary (11 percent), consumer staples (9 percent), basic materials (4 percent). Some advisors recommend that your ETF holdings mirror these market percentages. But you wouldn’t want one sector to get too heavy if you’re looking broadly to diversify—that’s how you could get hurt during a bubble. From most to least volatile, sector ETFs rank as follows: technology, financial, healthcare, consumer discretionary, industrial, materials, energy, consumer staples, and utilities. That makes sense, because you’re moving from most sophisticated in terms of inputs to least sophisticated.4
If you don’t want to just plug your money into an index of stocks, active investment is the way to go. You can pick individual stocks with exactly the exposure you want. Or you can hire a professional to do the picking for you. For active investors, an obvious choice is actively managed mutual funds. Their managers buy and sell as they see fit, rather than maintaining a certain group of stocks. The goal is to make a greater profit than you would by simply investing in the S&P 500, the Dow Jones, or some other index. Jim Cramer is an advocate of active stock picking. Warren Buffett is another guy who tries to outsmart the market, and he has a great track record in doing so. As Mark Riddix of Money Crashers writes, the good news about active investing is that it allows you to take advantage of holes in the market, gives you greater profit availability, and offers the opportunity of day-to-day control over your investments.
But there are downsides. First, if you go on your own, you have to invest a fair amount of time in research. You can have more taxable income since you’re buying and selling all the time, and every time you realize a profit, it is taxable. Trading fees can begin to stack up. And if you’re a bad investor, you’ll lose cash. Riddix recommends a combination strategy of passive and active investment.5
Passive investing typically beats active, according to Russell Campbell of Inside Investing. Most investors beat themselves by being too quick or too slow on the draw. But if you’re good, you can do great: “A check of Morningstar data as of the end of June [2013] shows that the median U.S. equity fund over the last 10 years has reported an annualized return of 7.94%. Funds that landed in the top 25% of the performance survey earned at least 10.00%. That is a difference of 2.06% per year after fees.”6 If you started with a portfolio of $100,000 and received a 7.94-percent return compounded for ten years, you would end with about $215,000. The same amount invested with a 10-percent net return would net slightly less than $260,000—quite an improvement. Over thirty years, the difference is even more remarkable. A 7.94-percent gain on $100,000 compounded over thirty years ends just below $1 million. But, the same amount compounded at 10 percent would rise to over $1.7 million in thirty years. So small performance differences compounded over a long period can make a major difference in wealth. Of course, the same argument can be made in the other direction—if you underperform over a long period because of fees or bad stock picking, you will end up with a lot less over time.
Are there opportunities out there? Some economists say there aren’t—they cite the efficient markets hypothesis and figure that it’s not worth trying to beat the market. There’s an old joke: Two economists are walking down the street. One sees a dollar on the ground and says, “Hey, look, a dollar!” The other says, “That’s not true. If a dollar were lying there, someone would have picked it up already.” The f
irst economist thinks about it and nods, and they both walk away.
But sometimes the dollar is there. If it weren’t, there wouldn’t be an efficient markets hypothesis. As one columnist writes at Seeking Alpha, “The irony of course is that without market participants seeking the mythological alpha, EMH falls apart. Like economists passing up free money, EMH proponents recognize collective market participation irons out mispricing, but seem to forget it’s real individuals who do the ironing.”7 Even Fidelity Investments recognizes that basic truth: “In a free-market economy, financial markets play a key role in generating and distributing information about corporate, private, and sovereign issuers through active management, which in turn fosters independent decision-making and the effective allocation of financial capital. The prevalence of information influences security prices. If an investor has favorable information about a security, it will often lead to the purchase of that security and drive up its price. Conversely, unfavorable information often leads to selling activity and downward pressure on prices. Thus, active strategies can be viewed as ‘price makers.’”8
An absence of active investors and a reliance on passive investment strategies has actually made the market more volatile. Everyone marching in lockstep can destabilize the market.9
Thanks to a nasty economy, financial planners like Ted Schwartz suggest that the only way to make true profit in the markets is to go more active:
Ed Easterling of Crestmont Research talks about two market climates: a positive climate, in which you can just set sail and let kind market winds propel your portfolio vessel in the right direction, and a difficult one that requires you to laboriously row to reach your goals. Because of the current global economy, which includes recession forecasts for Europe, I don’t believe Easterling’s beneficial climate is on the horizon. If you disagree, you might want to go heavy on passive investments. But if you agree with me, you should use some active investments to get where you want to go.10
Schwartz may well be right. Of course, there are always the investors who make active investing look far superior—people like Warren Buffett, Peter Lynch, and John Templeton, who not only beat the market but beat it with ease. The best way to beat the market is to know the market. As Prem Jain writes in the AAII Journal,
Buffett has proposed that investors think of making only a limited number of stock market decisions in their lifetime. Once they have made those decisions, they should not be allowed to make any more decisions. If you keep this in mind, you are unlikely to make many mistakes. To cement this thought, think about the effort you expended before you bought a house or a computer, before you decided to attend a particular college or accept a job offer. Because these decisions are not easy to reverse, most people make good decisions. If you think of buying a stock as a similarly long-term commitment, you will make better decisions.11
Even so, other experts favor passive investment. One of them is the investment great John Bogle, who founded Vanguard Funds and has spent his career trying to lead investors away from stock selection. “In the stock market, some investors do better and some worse, but their aggregate returns equal the market’s returns, minus the costs of investing. After all, they are the market. So if a fund matches the market’s gross return and does so at a cost much lower than the average fund, it will always beat the average fund over time,” he theorizes. He has been so successful in convincing people that about a quarter of all investing is done passively.12
“Disaster Economics”
What’s the best approach? It depends on your personality, the circumstances you are facing, and what’s happening in the markets. This is where it helps to have a properly trained professional to guide you through the process. It is also essential that this pro understand the risks of crisis investing. The National Security Investment Consultant Institute is training financial professionals to deal with the risks of financial terrorism, economic warfare, and general investment calamity.
Sadly, most investment pros assume “normal” markets and therefore are unprepared to address the threat of disaster. More and more countries are risking default on their debt, yet the markets are not responding appropriately. According to economists at Fulcrum Asset Management, that’s because so few analysts are working in the new global paradigm. They simply don’t understand the concept of “disaster economics.” People might want to prevent disaster rather than aim for higher profits. If so, analysts would miss that trend.13
Not all, though. Merrill Lynch understands that the U.S. economy is a potential risk. To offset the risk, they have recommended dumping gold and U.S. Treasury securities and looking at foreign assets like Australian sovereign debt and Singaporean bank bonds. “Unlike old U.S.-centric portfolios that called for nearly half of bond allocations being dedicated to U.S. Treasurys and municipals, [our] current models consider all bonds ‘global,’” the firm said in 2012. “Geopolitical instability is the new status quo. . . . As political powers shift and the global economy struggles to rebalance itself, investors might consider flexible investment approaches and a more globally diversified approach to their portfolio.”14 Merrill Lynch isn’t the only company making this argument. Saker Nusseibeh, chief executive at Hermes Fund Managers, told CNBC in September 2012, “What is different now is that political risk is now a factor in western countries and this risk is becoming more important than it has been before.”15
What should you do—or what should your fund manager do—if disaster strikes? You can sell stocks short (the legal way). The ability to buy long and sell short is a big advantage of the stock market. You can make money from a declining stock market just as you can from a rising market. In short selling, you borrow shares of a company and sell them. Later, when (as you hope) the price has declined, you buy those shares back at the lower price. You then return the borrowed shares and pocket the difference between what you sold them for and what you paid to buy them back. It can get complicated, but professional assistance can provide you with an important strategy during a crisis.
Above all, though, remember that stocks can perform irrationally in the short run. Don’t panic.
Irrationality was clearly to blame for the dot-com bubble, in which the market valued emerging internet companies at billions of dollars without actual revenues or even a business plan. Everybody remembers Pets.com. Thanks to easy credit and easy money, investors poured cash into software and the internet. The result was the growth of the internet—and the massive growth of a bubble that burst in 2000, wiping out tremendous amounts of stock. Hundreds of thousands of people lost jobs and their life savings. Jesse Colombo wrote, “At the peak of the dot-com bubble in 1999, it was said that a new millionaire was created every 60 seconds in Silicon Valley.” That couldn’t last, and it didn’t.16
On the other side of the equation, markets can be irrationally pessimistic as well. Rachel Beck of the Associated Press identified widespread irrational pessimism in 2009, and she was right. If you put your money in stocks in March 2009, when she called out the pessimists (and the Dow hit 6,627), you were doing the happy dance in September 2013, when the Dow hit 15,700.
Over time, however, the market adjusts, and the irrational optimism and pessimism average out. This is why stock market investing requires a commitment to the long term. The point is that you can invest in the stock market in a variety of ways, long and short, that can produce profits in nearly any environment. Most want to write off stocks because they fear turmoil when they should be embracing the opportunities there.
Where and How Do Stocks Make Sense?
So, when should you buy?
In a deflationary environment, it would pay to sell, if not short, most stocks. That makes perfect sense, because when prices drop, so do profits. If you’re convinced that the economy is going to tank in a deflationary collapse, call your broker right now and tell him to sell short. There is another option: You can buy high-quality, dividend-paying stocks—companies with great balance sheets that can consolidate their gains duri
ng the down times. Most strategists recommend cash and bonds (especially government bonds) during deflation.
In a time of inflation, even hyperinflation, stocks can perform well. A 2004 study from Harvard found a correlation between stock earnings and inflation.17 A personal example comes from my time at the Templeton Private Client Group. I met Sir John Templeton in 1987, when he was active in Latin American markets. Inflation in that region was terrible in the 1980s and 1990s; the regional average peaked at 438 percent in 1990.18
Sir John knew that. In 1985 he wanted to invest in Peruvian stocks, knowing that the government was printing cash at record rates. But Peruvian law forbade foreigners from investing. So he set up a local corporation, stashed $2 million in it, and asked Peter Gruber to run the portfolio. Soon President Fujimori came to power, and Gruber made a killing, bringing a 1,000-percent return for Templeton.19 Sir John bought stocks primarily because the massive inflation rates made them both a hedge and opportunity. And it worked.
The German experience of 1920s proves the point as well. It seems that stocks become one of the investments of choice (along with gold and hard assets) in times of high inflation. Even firms that paid a solid dividend of 20 percent were so overinvested that traders couldn’t make a profit. Getting in early during an inflationary cycle is crucial.20 The most recent example of this comes from Zimbabwe in 2007–2008, when the stock market was gaining hundreds of percentage points per day. “Why leave money in the bank? People are forced to come on the stock market. They believe that after hard currency, the stock market is the only viable option where you can get a bit of a return,” explained Emmanuel Munyukwi, chief executive of the Zimbabwe Stock Exchange.21
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