On the other hand, what if central bankers stateside weigh the benefits of permitting a smaller recession today to avoid a massive speculative bubble from exploding down the road? What if letting some air out of the severely overvalued equity and debt markets now makes more sense to committee members than riding to the rescue at the first sign of fragility? After all, it is well-documented that neither Greenspan nor Bernanke – chairmen of the Fed prior to Janet Yellen’s arrival – were able to respond quickly enough to prevent the monstrous dot-com disaster (2000-2002) or the systemic financial collapse (2008-2009).
In spite of the NASDAQ 5000 headlines, other signals have been flashing yellow. Margin debt on the NYSE, a sign that investors are willing to borrow to leverage upside gains, has been declining steadily. Margin debt currently sits below a 12-month average. Similarly, the NYSE Composite has not been able to break above resistance levels set back in July.
So how might one handle the high likelihood of a stock market pullback? Apply insurance principles to the investing process. A 65%-35% growth-income investor might decide that a better tactical asset allocation for the current environment would be 50%-30%-20% such that the 20% cash buffer acts as a intermediate-term insurance policy against a sharp downturn. The cash buffer might also be employed in a corrective phase; that is, one can incrementally purchase equity and debt during the pullback, averaging one’s way back to the 65%-35% target.
Others may wish to employ a multi-asset approach to stock hedging. Specifically, there are certain assets that have historically succeeded at a time when stocks are being eviscerated. Currencies like the Swiss franc, U.S. dollar and the Japanese yen – each for different reasons – tend to appreciate in stock market bears. The sovereign debt of Germany and Japan have acted as safer havens. Precious metals like gold have often seen strong demand. Finally, a wide variety of U.S. debt – munis, zero coupon, long-term treasuries, inflation-protected – were winners in the 2008 catastrophe and the 2011 eurozone crisis.
For those who wish to beat the bear without shorting or leverage, combining a wide variety of bear-bashing assets may be preferable than T-bills or cash alone. One can look to track an established index like the FTSE Custom Multi-Asset Stock Hedge Index or purchase individual ETF components with potential. For instance, inflation expectations may be non-existent, yet the iShares TIPS Bond Fund (TIP) has still provided low-risk value to its owners with a 1.3% total return in the first few months of 2015.
