A Crash Proof Investment Strategy

Financial markets and institutions are mighty unstable no matter where you look these days. Europe, America, China, Australia. Where are you supposed to go to invest your money?

Geography isn’t the only maze full of dead ends. Traditional asset allocation theory has its knickers in a twist too. None of the asset classes are doing what they are supposed to.

  • Government bonds are proving dangerous, particularly in Europe. Academic theory tells you they’re risk free (which explains how the Greeks got away with profligacy for so long).
  • Stocks have been going sideways for years. They are supposed to go up with the occasional correction. That’s the whole point of having such a large part of your Superannuation invested in them.
  • 2011 proved that property prices do not always go up, even in Australia.
  • Gold, that barbarous relic which pays no interest, has been going up in virtually a straight line, to paraphrase Alan Kohler when we spotted him on TV sometime last week.

And we’ve learned from the MF Global scandal that your brokerage might not actually have the things you supposedly own with them. Clients discovered their investments and cash were both outside of their trusty brokers reach.

Of course, everything that can go wrong is interconnected. A crash or default in any one asset class or country will unleash havoc in the others. That’s what happened in 2008 – a problem in the obscure sub-prime lending market had investment banks dropping like flies within the year. Or faith in a major institution could be the cause of another global economic slowdown – another Lehman moment. The trigger everyone has their eye on this time around is of course Greece. It only takes one domino to fall before the rest reach their tipping point.

Then again, some plonkers seem to think that lining up dominoes decreases the chances of any specific one being knocked over.

Ian Verrender in The Age:

The only way that we will experience a US-style property crash here is if there is a serious rise in unemployment – a change that would spark loan defaults and flood of distressed property on to the market… For a US-style property collapse to occur here, we would need sovereign debt defaults across Europe, the disintegration of the European Union and a banking crisis that would cripple even China.

It only takes one of the scenarios Verrender mentions to happen, not all of them, for Australian property to be in trouble. Because all will follow on from each other.

For example, the IMF recently released a report warning China that Europe’s woes are set to halve Chinese GDP growth. ‘That would entail a growth rate far below the level the ruling Communist Party has identified as necessary to create enough jobs for it to maintain its grip on power.’ Let alone prevent the expected banking crisis!

But wondering which domino will fall first may prove academic. It won’t take you long to find evidence that all three criteria needed, according to Verrender, to set off a house price crash in Australia are already being met. Rising unemployment in Australia, sovereign debt defaults across Europe and a banking crisis in China. And Verrender may have causation the wrong way around to begin with. Falling house prices, as we had in 2011, can cause the unemployment that sees house prices continue to fall. In other words, the Australian house price bubble could be the first domino to fall, triggering the others.

When Is a Crash a Crash?

Of course, Australia wouldn’t be the only country in trouble in a world of banking crises, sovereign debt defaults and crashing asset prices.

Despite all this, equity markets are plodding along nicely so far this year. But the suddenness of a turning point can change that very quickly. A seemingly insignificant event on the global stage, like the bursting of a housing bubble in Australia, has the power to trigger a heck of a lot of global turmoil in a short space of time.

Turning points come in many shapes and sizes. Let’s sample a few of the past:

Property – Gareth Brown, also upset with Ian Verrender’s analysis of the Australian property market, reminds us that ‘the Case Shiller Index of US big city house prices fell a lesser 4.3 per cent in the year to September 30, 2007. By the time 2010 rolled around, it was down 30 per cent.’ Not to mention the global financial crisis the property crash triggered.

Shares – Monday 19 October 1987 saw a 22% drop in the Dow Jones Industrial Average. Australia’s stock market went on to fall 40% by the end of month. Marc Faber, who warned people to get out of the stock market a week before ‘Black Monday’, recently said ‘I think the stock market this year has started in a similar way as in 1987’. We still don’t really know what caused the 1987 selloff. But it happened in a similar year.

Sovereign bonds – Our favourite sovereign bond crisis is the Russian Ruble Crisis of 1998. Long Term Capital Management, a hedge fund run by the academics whose theories university students now learn, needed a bailout after that episode. Bailouts have been priced into sovereign bond investing ever since. The trigger, on August 13, was a 200% yield on Russian bonds. Also worth mentioning is that $5 billion in World Bank and IMF aid loans were stolen on arrival.

Bank failures – It’s not just nations that fail. Lehman Brothers’ botched bailout and subsequent disappearance showed how a single failure can cause mayhem throughout the entire global financial system.

So there’s your summary of some of the crises and their turning points. Now get this. Australians are nicely lined up to experience all these types of problems at once.

We face a sovereign bond crisis in Europe, a property bubble here, banks overexposed to both of these, a resource sector over exposed to a Chinese construction bubble and a stock market made up of banks and resource companies.

If turning points and triggers start showing up in any of these exposures, things could go downhill fast. And you will want to ready your portfolio to weather the storm. So you have to ask yourself the following questions:

At what point is a falling stock market a crash?
At what point is a falling property market a crash?
At what point is a state going to default?
At what point is a bank insolvent?
At what point is a 20-year recession-free run going to come to a crashing halt?

When we finally learn the answers to those questions the hard way, it will be too late for the vast majority of people to protect their wealth. Or they will have done it inadequately. This video demonstrates nicely how a crisis trigger can have unexpected effects. While your attention is drawn to the action, the real crisis draws near behind you.

We don’t have any particularly good answers to the questions about when a fall becomes a crash, a liquidity problem becomes a solvency problem and a recession becomes a depression. But you don’t have to answer those questions about the timing of a crisis to protect your wealth if you can answer this one: How do you make the questions less relevant? We have an answer for you this week. At least part of it. The other half remains hidden, except to subscribers of Australian Wealth Gameplan.

The solution to unstable investment markets is a stable portfolio. And what’s more stable than permanent?

Graham’s Intelligent Investor vs. Browne’s Permanent Portfolio

We tried to read Benjamin Graham’s famous book ‘The Intelligent Investor’ over the last few months. It was like being back at university – that place where you learn things while they are being disproven in the real world. The first few chapters of the book explained why bonds were a good bet in the current environment. Inflation isn’t likely to take off, Graham reckoned. ‘We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say 3% per annum.’ Unfortunately, we were reading the 1972 edition. Eight years later, inflation was running at five times the assumed rate. And it spent the next decade above 3%.

Inflation 1965 – 2011

Inflation 1965 - 2011

US inflation took off in 1973, reaching 15% by 1980

Reading pages and pages about why inflation should stay low and bonds are a good investment, knowing the disastrous consequences for those who followed his advice, made the book, to the point we kept reading, rather unpleasant.

Here is where Graham went wrong with his advice. Famed investor Warren Buffett wrote in his introduction to the book that ‘the underlying principles of sound investment should not alter from decade to decade, but the application of these principles must be adapted to significant changes in financial mechanisms and climate.’ Adapting principles is how you introduce human error. The whole point of a principle is that, if you stick by it, you won’t stuff up the adaptation.

That’s why we prefer Libertarian Harry Browne’s ‘permanent’ solution to Benjamin Graham’s ‘adaptations of principles’. What’s ironic is that Browne’s book, published in 1970, made the accurate prediction about inflation that it didn’t need to make for the strategy to pay off. Browne foresaw the very thing Graham got explicitly wrong – the inflation experienced from Nixon going off the gold standard. Well, Browne expected a devaluation, not a complete decoupling. But his strategy didn’t depend on it. Despite calling his book ‘How you can profit from the coming devaluation’, the investment strategy Browne championed was a completely neutral one – the Permanent Portfolio. The idea being that you didn’t have to adapt diddly squat to any ‘changes in financial mechanisms and climate’. Apart from reweighting occasionally, you don’t have to give the asset allocation a bit of thought. It’s all laid out for you.

So what’s in the Permanent Portfolio? Australian Wealth Gameplan subscribers have known since August. They’ve also been profiting from what editor Dan Denning calls ‘The Revolution in the Desert’ since June. And in this case, profit means two tips up over 120% at last count.

To get in on the action click here.

Nickolai Hubble.
Markets and Money Weekend Edition

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Nick Hubble
Nick Hubble is a feature editor of Markets and Money and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about Markets and Money, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails.

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Rick W

Crashes are easier to define after the event than at the onset. However there are plenty of examples to show that Australia is past the onset of a crash. Scan down these listings, particularly the ones that have a history of 3 years or so:

It appears that many areas of Melbourne are well past the onset phase as well:

Steve Keen provides some insight into the shape of a crash on his blog:

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