How about 2011? Until the European Central Bank assured the world that it would do whatever it takes to protect hopelessly indebted borrowers like Greece, Portugal and Spain – until the U.S. Fed served up its third round of controversial quantitative easing (QE3) without a stated end date – investors refused to take any risks. Instead, they paid astronomical premiums to own U.S. treasuries, gold and/or the greenback to avoid exposure to the possibility that over-indebted countries would be allowed to default.
In essence, the crises of 1998, 2008 and 2011 shared a common element of borrowed money. The depth and length of the ensuing investment panics differ based on the responses by the parties in charge of the bailouts.
It should be noted, however, that the ability of central banks to ride to the rescue was much greater in previous years than it is today. This brings up the second implication for investors in this late-stage, debt-fueled economic expansion. With the U.S. economy showing unfriendly indications of eroding strength, and the Fed still angling to maintain credibility with an attempt to push overnight lending rates a “smidge” in the direction of tightening, how long before the central bank of the United States will find itself needing to reverse course? Will they be able to do it fast enough to maintain record levels of margin debt betting on ever-pricier stocks continuing to appreciate in value? Or, as history suggests about over-borrowing by governments and financial institutions, when a perceived “moral hazard” eventually happens, will the rush to sell risk assets trigger margin calls. Throughout history, record margin debt eventually turns such that those involved are forced to sell positions. That reduces the value of the collateral, setting off more margin calls and triggering more selling and more margin calls until, eventually, the entire market-based universe is battling to get out a tiny exit hatch.
The final implication for investors is, “What should I do now?” Plainly, you need to invest for your goals, but plan for the worst. This is achieved by pruning winners, dumping losers and raising cash for future opportunity. For example, maybe you have held SPDR Select Health Care (XLV) for the last five years. And maybe it represented 7% of your portfolio when you began, but now it represents 12%. As much as it may pain you to reduce exposure on a long-time winner with few signs of slowing down, rebalancing back to the original 7% is the sensible move in a latter stage-bull market.
By the same token, you may have a few losers in your portfolio that you had tremendously high hopes for when you bought them a year or two earlier. For instance, let’s say that you went into 2014 with the well-researched belief that consumer discretionary spending would benefit the gaming sector more than any other. So you purchased the sub-sector investment, Market Vectors Gaming (BJK). After all, a massive increase in tourism to Macau in Asia had already led to the island generating more than 5x the revenue of Las Vegas. Other countries and other states were in the process of loosening regulations on casino development. And even the casino operators in Las Vegas has been expected to report fabulous growth. Nevertheless, BJK has been disappointing enough for an investor to take his/her lumps and raise cash for a better allocation down the road.
Finally, having cash for future investment in a late-stage bull should be looked upon as an asset. Far too often, you will hear folks complain about their money making no money in accounts with virtually no interest. On the other hand, there is a reason that Warren Buffett has $65 billion sidelined in non-productive cash. One of the most famous investors on the planet is patiently waiting for the next panic, crisis, crash or sell-off before redeploying into a growth or income champion.