February 22, 2011
By Joe Smalley, AIF®
As history unfolds in the Middle East, the waves of revolt have finally been felt in the stock market. The S&P 500 is down 2% this week. While protests in Tunisia and Egypt were widely followed because of their historic significance, the bloodshed in Libya is causing investors to seek safety. This is due, in part, because of the violence, but also because Libya is an exporter of oil. As such, the price of oil has spiked 4.4%. While Libya’s oil is only 3% of the world-wide production of oil, it is an important part as the quality is high, and Europe is one of the larger buyers of their oil. But more importantly, there is fear in the marketplace that if Tunisia can experience regime change, that is one thing, but if Libya and strong man/dictator Gadhafi goes down, then all bets are off. A month ago it was not conceivable that the revolt of the people would topple governments in the Middle East. Now, it is not only conceivable, but some think, inevitable. That means that the Kingdom of Saudi Arabia could potentially face revolt, as well – which could mean that oil prices might spike considerably more, which has investors increasingly nervous.
Oil is just one commodity that is rising. Food prices around the world have gone up significantly. In fact, that is much of the cause of the revolts to begin with. On top of the higher food and energy costs, global housing, medical care, transportation, and apparel are all on the rise. This is where the consumer faces the biggest challenges – when wages do not keep pace with inflation. For example, if gas prices go from $3.30 per gallon to $4.00 per gallon, for many families, that means that they do not spend that extra $0.70 per gallon at the movies, or out to dinner. The increase has to come from somewhere. Although prices are elastic, family budgets are not.
Unfortunately, that is not the case with governments. Often, instead of reducing spending, governments attempt to stimulate economic growth by using monetary policy to essentially print money, or to use fiscal policy to borrow more money. Either way, it is a risky gambit. With an increasing structural deficit, countries are playing chicken with investors who buy their debt. Just look at Greece, whose borrowing costs went from up significantly when their debt ratings were downgraded. Just this morning Moody’s Investor Service downgraded Japan’s debt rating from stable to negative. And the United States is not without its own problems. The Federal Reserve has begun to buy the very assets that the US Treasury is selling at auction – Treasury bills. That means that one unit of the federal government is raising money by selling bonds, while another government unit is buying those very bonds with money that they are printing out of thin air. Let me ask you, how long is that sustainable?
Kyle Bass, the Managing Partner at Hayman Capital Management, sees the growing global debt problem as potentially a game changer. “Since 2002, global credit has grown at an annualized rate of approximately 11%, while real GDP has grown approximately 4% over the same timeframe. Without a resolution of this global debt burden, systemic risk will fester and grow.”
Pretty dire stuff, eh? Since 2008 when the financial markets collapsed under the weight of the credit crises, the stock market has bounced back nicely. With the government using every tool in the tool chest (and to extend the metaphor, when they ran out of tools, they built a tool maker, and made more tools), the economy came out of free fall and the stock market regained much of what was lost. There is a saying on Wall Street – “Don’t fight the Fed.” What that means is, buy what the Fed is buying. In this case, it is assets. And it has worked. The S&P 500 is up more 6% year-to-date, and more than 20% in the last twelve months. People are actually opening their investment account statements again. The market has continued to perform another Wall Street saying of “climbing a wall of worry.”
But as inflation continues higher, the appetite for expanding the Fed’s balance sheet, in my opinion, will wane. But by then, the damage might be done. We now face the largest deficit in our country’s history and are close to reaching the Congressionally mandated debt ceiling.
So, if you believe what I just outlined, what is an investor to do? Well, bluntly, it is time to reduce your exposure to risk assets. You may want to review your asset allocation and really take a look at the level of volatility you are willing to take. You may want to introduce non-correlating assets to your portfolio. Interestingly, during the last downturn, many of the asset classes moved in lock step to each other. Non-correlating assets are not supposed to do that. You may want to consider adding commodities to your portfolio. And you might want to include investments with hedges. Bottom line, you might want to pull some of those profits off the table. There is another Wall Street saying, “no one ever went broke taking a profit.”
Making investment calls, as many of you know, is not what I do. Today, I am not saying to sell everything and to put it under your mattress, but I am suggesting that you review your situation, and if appropriate, reduce your risk.
One way to do that, is putting in place a financial plan. Using a plan can help you forecast your financial future based on different scenarios, and is a good way to see if you are on track for meeting your life goals. Because we are not day traders or hedge fund managers, we do not invest simply to move money around or to make an absolute return – we invest to send our kids to college, or to retire when we want to. A financial plan can help you to articulate and meet your goals. Please call us to schedule a review of your situation.
Also, this might be a good time to consolidate accounts. If you have orphan retirement plan assets or accounts held directly at mutual fund companies that you would like to bring in, please contact us. We can consolidate everything under one roof.
Markets move; that is what they do. It’s best if your portfolio reflects your goals. Let us help you create a plan to align your goals with your investments.