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Jubak's Journal
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• 5 keys for a big finish to 2004, 6/11/2004
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A 5-step plan for surviving the storm
The end of cheap money could bring a market disaster -- but if it doesn't, you don't want your money stuck under the mattress. Here's how to forge ahead in ominous times.
By Jim Jubak
How do you plan for a potentially disastrous event, such as the popping of the current cheap-money bubble, if you dont know when, where, or ultimately even if the disaster will occur?
About two weeks ago, I wrote a column (Why all market bubbles end with a bang") arguing that the cheap-money bubble that the Federal Reserve had created by guaranteeing short-term interest rates of 1% for so long is due to pop. Rather than deflating gently, the bubble is still expanding and, as is typical of the end stages of a financial bubble, at a faster rate. That, in turn, increases the risk that some part of the financial system will blow up.
Unfortunately, I argued, the system of credit and debt is so complex and disclosure so minimal that its just about impossible to pinpoint where or when the bubble will burst. Or to tell how extensive the damage might be.
The column generated a lot of mail, and the letters all had a similar refrain: Yeah, I agree with you that this bubble is dangerous, but stop frightening me to death and tell me what to do about it.
Fair enough. So heres my take on how to plan for the end of the cheap-money bubble:- Analyze the cost of the potential disaster and weigh your ability to recover from the disaster.
- Look for steps that reduce the cost of a potential disaster as much as possible.
- Buy insurance to cut the potential cost of any disaster even further.
- Compare the cost of missed opportunities to the cost of recovering from the disaster.
- Repeat steps 2, 3 and 4 as the news changes and the odds of a perfect storm striking go up or down.
Step 1: Consider the cost
The bursting of the credit bubble isnt likely to be as painful in magnitude or duration as the 80% drop in the Nasdaq Composite Index ($COMPX) from March 10, 2000, to Oct. 9, 2002. But its certainly prudent to think about what something like the negative 11.8% total return from Treasury bonds in the three-month August-through-October 1994 plunge or the 31% plunge in the Standard & Poors 500 stock index ($INX) from September through November 1987 would mean to you.
Dont focus on the raw numbers themselves but on their effect on you. A 12% loss over three months is one thing to someone with a healthy cash cushion in the bank and something else entirely to someone who is counting on that money to pay a college tuition bill or, worse yet, to meet a mortgage payment. What you want to do at this stage of planning is to figure out how much damage a perfect storm would do to you if it struck.
Step 2: Lower that cost
Because its just about impossible to predict when a financial perfect storm will strike, or if it will, most of us cant afford to just move all our investments to cash and wait for the storm to blow over. What if that takes a year or two years or five? What if investors never get an all clear signal? I dont know about you, but Im trying to put aside money for college tuitions and retirement and to pay off a mortgage. I cant afford to put my money into a 2% CD for three years. The cost in lost potential gains is just too great. But short of going all to cash, I can take steps to lower the cost that I calculated in Step 1.- Start with the liability side of your personal balance sheet. Reduce or eliminate as much debt as you can. Build up a cash reserve so that short-term blips in the market stay just that. Make sure that a surge in interest rates of a point or maybe two wont push the interest payments on any adjustable-rate debt you owe to a level that you cant manage. Limit the damage to the short term.
- Then move to the asset side of your balance sheet and look at the risk youre carrying there. If your portfolio is stocked up with high-beta stocks in the technology or biotechnology sectors, consider reducing your exposure by selling into rallies in these sectors. Comb through your portfolio looking for bonds or bond funds with above-average exposure to rising interest rates or shares of financial companies that might be heavily invested themselves in the more leveraged instruments of the bond and derivative markets.
Step 3: Insure yourself
Reduce your exposure to disaster further by buying financial insurance. This is tricky when youre planning for an unpredictable event that could be well off in the future. Many forms of financial insurance -- options, for example -- expire in relatively short periods of time.- There may come a point in waning days of this bubble when the popping of the bubble seems sufficiently near that using options to insure against the risks will make good sense. If we ever reach that degree of certainty, it will then be worth thinking about betting against volatile market segments such as the Nasdaq 100 or the semiconductor sector by buying put options that give the buyer the right to sell at a specific price, or by shorting an ETF such as the Semiconductor Holders (SMH, news, msgs).
- With the current degree of uncertainty, most investors are better off using the shares of natural resource companies, and gold and oil companies in particular, to hedge against the perfect financial storm. Gold shares climb on financial turmoil as investors flock to the security of the precious metal. Oil stocks pay solid dividends, so this insurance pays you while you wait to see if its needed. Plus, since the oil market operates in dollars, the price of oil tends to rise when the dollar gets weak, as it might in a period of financial chaos. Oil stocks have pulled back lately, and this gives investors a window for adding to this hedge. (Im adding shares of ChevronTexaco (CVX, news, msgs) to Jubaks Picks with this column per my May 25 column, Its time to buy oil stocks, not sell them.") I think gold stocks will show a similar pullback and buying opportunity if the Fed raises interest rates at the end of June.
- And dont forget that cash is a great form of insurance and that you dont need to sell everything or go all to cash to use it. Selling out when a stock hits your target price and then using all or part of the proceeds from that sale to increase your cash position increases your financial cushion and also gives you the cash to take advantage of any post-storm buying opportunities.
Step 4: Invest while you wait
Remember while youre waiting for the cheap money bubble to pop, and hoping that it wont, that you still want to and may indeed need to make money in the markets. The long-term probability of the perfect financial storm has to be set against the short- and intermediate-term prospects for the stock market.
As I argued in my June 11 column, 5 keys to a big finish for 2004, I think stocks have a reasonable chance to finish up about 10% for the year. In the even shorter term, the market looks like it is setting itself up for a decent rally in July if the Fed raises rates, if the transfer of sovereignty in Iraq isnt any messier than now seems likely and if we get through the July 4 holiday without a big terrorist event. I dont want to pass up the opportunity for any of those gains -- money that you dont make is a setback to your financial plans, too.
For the rest of 2004 -- the intermediate term -- Ill be looking toward the same kind of low-risk growth stocks that Ive been adding to Jubaks Picks for most of this year. Ill be looking for solid growth stories in low-risk sectors such as defense, food, consumer products, manufacturing, and gambling. And Ill be looking to buy that growth at a reasonable price and to avoid high-beta stocks that will fall more quickly than the market as a whole in any downturn.
For the next month or six weeks -- the short-term -- Id be willing to take a nibble at a stock or two in the much more volatile technology sector, with the idea of selling into the end of the rally. In any relief rally, these high-beta stocks will move up faster than the market average, and I dont think the risk climbs dramatically on this sector until the Federal Reserve has raised rates twice. At least, thats what market history suggests.
Step 5: Readjust as you ride it out
Repeat steps 2, 3, and 4 as needed. Investors are dealing with constantly shifting odds of the perfect financial storm. If inflation reignited, the Fed would be forced to raise interest rates more aggressively than anticipated, which in turn could destabilize some major Wall Street players. An event like that would make me go back and reduce risk further, add more insurance and pull in some of my short-term and intermediate-term investments. Other events that would make me go through the process again include a huge spike in oil prices to $50 a barrel, a serious threat to Saudi Arabia or surprising weakness in the dollar.
One final thought: Even if the Fed and all the other global players manage, against the odds, to deflate the cheap money bubble without a pop, investors and the financial markets will still face the structural overhang in U.S. and global debt created by the aging of populations in the developed world and the failure of governments and populations in many of those countries to save for a rainy day.
Investors will have to cope with the effects of that long after this cheap money bubble is history.
Changes to Jubak's Picks
Buy ChevronTexaco
ChevronTexaco's (CVX, news, msgs) share price dropped just 2% after the OPEC (Organization of Petroleum Exporting Countries) announced that member states would pump more oil. Thats not as much of a drop as I was anticipating in my May 25 column, Its time to buy oil stocks, not sell them, but it looks like its about as much of a dip as investors can expect. Everyone seems to know that nobody in OPEC except Saudi Arabia has the capacity to up oil production, and even the Saudis dont have enough extra oil to change the current price by much. As a result of Wall Street disappointment with the cost savings from the Chevron/Texaco merger and skepticism about the success of the companys exploration program, ChevronTexaco trades at a substantial discount to its oil industry peers with a price-to-earnings ratio of 12 vs. the industry average of 16 and a price-to-sales ratio of .84 versus the industry average of 1.01. But results in the companys first quarter were surprisingly strong, showing that the company has the ability to close at least some of the performance gap with the other industry majors. Im adding the stock to Jubaks Picks with a target price of $99 a share by December 2004. Add that potential capital gain to the stocks 3.2% dividend yield and ChevronTexaco promises a solid return with below market-average risk.
New developments on past columns
3 big threats to Chinas economic miracle
It seems to be working, at least a little. Chinas efforts to slow its runaway growth without crashing the economy paid off in May. Industrial output rose in May by 17.5% from May of 2003, according to the National Statistics Bureau. Thats terrifyingly rapid growth by U.S. standards, but it was actually an improvement from the 19.1% growth recorded in April. More evidence came in from Chinas central bank, the Peoples Bank of China, which reported that bank loans grew by 18.6% in May 2004 from May 2003, down from 19.8% growth in April. Its still an open question whether these measures will be enough to stem the rise in inflation in China. Consumer price inflation hit 4.4% in China year-to-year in May. Thats below the 5% line in the sand drawn by the Peoples Bank but not by much.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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