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Two Ways to Prepare for Shock Events in the Financial Markets

Stock-Markets / Financial Markets 2010 Aug 28, 2010 - 11:53 AM GMT

By: Bryan_Rich

Stock-Markets

Best Financial Markets Analysis ArticleWith bond yields and stock markets in the world’s major developed economies petering away, more people are asking: Where can we find investment returns?

Wall Street’s answer: Emerging markets.


The long-term growth prospects in emerging markets are certainly attractive. But with the propensity for another round of global economic crisis and the intertwining of economies, the risk associated with those investments is quite high.

The economic outlook for major economies has deteriorated rapidly. That means we’ll almost certainly see more shocks or “tail-events” in financial markets.

And given the nature of the economic crisis — one defined by unsustainable debt — history suggests those shocks will come in the form of sovereign debt defaults and currency devaluations.

These types of events by definition are thought to be “low probability” occurrences. But as we’ve seen in recent years, they tend to show up with surprising frequency in crisis environments, and they tend to be very destructive.

And it’s prudent to expect that events like these will raise the specter of risk for every region of the world and will likely damage investment returns for the entire global economy.

So, with this backdrop in mind and with asset prices and bond yields falling, where do you find returns?

Here are two ways to consider …

Return Mechanism #1: Cash

We’re experiencing a balance sheet crisis. And it’s left consumers, companies and governments trying to climb their way out of a hole of debt.

That’s why it’s becoming abundantly clear that deflation is a big threat, despite all of the money printing. You can flood the world with paper currencies, but you can’t make those who have been buried by debt spend or borrow again.

There’s obvious and significant deflation in some key areas of the economy, for example housing. And other broader price measures are poised to follow.

In a deflationary environment cash is king …

As prices fall, your money buys more. But that money tends to be harder to earn.

Cash is king when prices are falling.
Cash is king when prices are falling.

In this environment cash can provide shelter and generate returns …

Raising cash can help you avoid being exposed to the tail-events likely in store for financial markets.

As for returns, it’s important to pay attention to real returns. Real returns are returns after the effect of inflation, or in this case, perhaps deflation. It’s the true measure of whether or not your purchasing power (or wealth) has increased.

For example, if consumer prices decline by 3 percent, the purchasing power of your cash would increase by 3 percent … the equivalent of earning a 3 percent return.

Return Mechanism #2: Opportunistic Trading

The tail-events I mentioned represent a lot of risk, but only if you’re on the wrong side. Positioned correctly, they represent opportunity.

So what is the correct position in this environment? The answer is the same as it would be in any investment environment …

Investors should always be positioned in such a way that the expected return of an investment more than compensates them for the risk taken.

With the increasing probability of a double-dip recession and more emergency policy responses likely to come, the risks of traditional buy and hold strategies clearly outsize the potential rewards.

Instead, the better reward-to-risk profile is more likely found on the short side: Positioning for a fall in stocks, commodities and many foreign currencies, especially those relative to the safe-haven favored U.S. dollar, as markets adjust to a protracted period of depressed demand.

Investors could profit handsomely from struggling foreign currencies.
Investors could profit handsomely from struggling foreign currencies.

An even better payoff could come if tail-events, like sovereign debt defaults and currency devaluations, materialize.

We’re already seeing the scrutiny return in Europe …

This week S&P downgraded Ireland’s government debt. And sovereign credit default swaps for the weaker European countries recorded the sharpest monthly increase on record.

The deflation threat has clearly caught many people by surprise. And with the reality that yields will remain at record lows for the foreseeable future, achieving investment returns by traditional strategies and asset classes has proven to be difficult.

I’ve described a few ways to generate return in this environment. But remember, return OF capital can be every bit as important a concern as return ON capital in this crisis period.

Regards,

Bryan

P.S. I’ve been showing my World Currency Alert subscribers how to use exchange traded funds to profit from rising and falling currencies, like the euro, the yen and the pound. Click here to discover more.

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.


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