Stay Defensive, Keep Cash on Hand as Stock Market Risks Build

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Using a defensive strategy and having cash ready to take advantage of buying opportunities is crucial for investors who want to weather tough times and protect their portfolios.

With global recession concerns looming, knowing what economic indicators to watch is more important than ever.

As many economists will tell you, looking back is often a good way to know what lies ahead due to the cyclical nature of the market.

This strategy was on display at the New Orleans Investment Conference, held in mid-October. At the annual "Booms, Busts and Bubbles" discussion, panelists explained how the current economic landscape compares and contrasts to past environments.

Lessons learned from 1929's big crash

Moderated by Luma Financial's Albert Lu, the panel began with a look at what conditions heralded 1929's Wall Street crash.

“Whether you're a Keynesian or monetarist or Austrian, new school or old school, everyone seems to agree that speculation was at fault,” Lu said about the century-old rout. “Whether it was government-enabled speculation or unfettered free market speculation, the consensus is that excesses and speculation are what set the stage for that crash.”

He then asked James Stack, president of InvesTech Research, to consider how that period and today are similar. Stack explained that the 1929 crash took years to build before the bubble burst.

“In the late '20s, we had investment trusts, very similar to mutual funds, except investment trusts were investing in other investment trusts, investing in other investment stuff. So you kind of ended up with this pyramid scheme,” he said.

Aware of the issue and working to combat the inflating market, the US Federal Reserve began “tightening.”

“They did a half point rate hike, which was traditional, another half, another half, another half; and then by the summer, they got so frustrated they raised a full percentage point,” Stack said. “And that was the pinhole.”

According to a 1965 report available on FRASER — a digital library of US economic history — in 1929, yields on four to six month commercial paper rose from 4 percent to 6.25 percent, while interest rates on the highest-grade corporate bonds increased from 4.5 percent to 4.8 percent. As it stands today, the federal funds rate is set at 3.75 percent to 4 percent.

“Bubbles, you have to remember, are psychology driven, but they're often monetarily fueled, supported, much like valuations today are supported by ridiculously low interest rates,” Stack said told those watching the panel. “But ultimately the pinhole traditionally — stepping back — comes from the Fed.”

Easy come, easy go: The lure of fast money

The panelists attributed the economy's current woes to quantitative easing (QE) — or, more specifically, the money it has created.

“Cheap money always drives the speculative juices,” said Peter Boockvar of Bleakley Financial Group. He also offered the following analogy: “Easy money, zero rates and QE put beer goggles on investors. And when you drink too much, everything looks good.”

Excess cash can also offer a false sense of security, according to Boockvar, who explained that it was also a problem during the 1929 crash, the dot-com bubble burst and the 2008 financial crisis. “Easy money is just sort of the liquor or fuel for making things look good and encouraging people to take risks that they wouldn’t take otherwise,” he said.

With over US$46 billion in the total US stock market alone, Stack said we may be heading towards a larger problem.

“The concentration in stocks is extraordinarily high today,” he said. “That creates a risk.”

Although the overall pool of stocks has grown in the last 30 years, the InvesTech Research head explained that the group of stocks that make up the top earners has continuously declined.

He referenced InvesTech's Gorilla Index, which shows that 20 percent of S&P 500 (INDEXSP:.INX) stocks accounted for 80 percent of the market's gains in the years leading up to the tech bubble bust in the late 1990s. “Today it is even higher, far higher,” he said. “We have a new Gorilla Index (with) 10 stocks that are contributing an outsized amount of gains in the S&P.”

Stack believes that the initial cause for concern in the present bear market came in the spring of 2021. “We saw the speculative stocks peak in the second quarter of last year. We call those canary in the coal mine stocks; they died early,” he said. As speculative stocks reversed course and turned negative, next in line were the 10 Gorilla Index stocks.

Stack then brought up a niche group of stocks. “The must-own stocks a year ago were the FANG stocks,” he said, listing (NASDAQ:META), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL) as the stocks in question.

“The S&P is down 25 percent, the four FANG stocks, collectively, year-to-date on an unweighted basis, are down over 50 percent,” Stack said. “So the damage in this bear market is already much greater than perceived by the public.”

Applying lessons from the past to the world today

Offering some optimism, Stack did mention some silver lining tips for those in attendance.

“All of these situations ultimately led to one of those great buying opportunities, particularly in equities,” he said. “The key is to make sure that your portfolio has enough defenses so you can take advantage of that.”

On the flip side, Boockvar warned of the potential problems investors face in market downturns.

“One of the other characteristics of a bear market is death by a thousand cuts, where the bear market just grinds you down,” said the chief investment officer at Bleakley Financial Group.

He is also concerned with how enmeshed the economy and market are presently.

“The problem is that the economy is so intertwined with the markets that all you need is a valuation rethink, and the market goes low, and that market that's lower then impacts consumer spending,” Boockvar added.

Wrapping up the discussion, Lu asked each guest to offer some thoughts on asset allocation given the current situation.

“First of all, don't make investment decisions based on your outlook for inflation,” said Stack, again emphasizing that there have been some great investment opportunities in high inflationary environments before.

He advised having hard assets in your portfolio, but limiting the amount to 10 to 15 percent.

“That is your defensive hedge, mainly against currency risk,” he said. “You want to see gold soar? Wait for the peak in the US dollar.”

With the remainder, he recommends building up defensive cash reserves.

“We came into this year close to 70 percent invested; today, including our inverse fund portfolio, we are less than 40 percent invested in the stock market,” Stack said. “That is the lowest investment allocation we've had since the worst of the tech bubble back in 2001/2002. That is how worried we are about this market today.”

Boockvar also thinks bolstering cash positions is wise, but believes some of it should be used to benefit from the market’s bottoming. “The bottom is the best time to buy stocks,” he noted. “The cheaper you pay for something, the better your long-term returns.”

Want more content from the New Orleans Investment Conference? Click here to read our recap of the event, and click here for our full interview playlist on YouTube.

Don't forget to follow us @INN_Resource for real-timeupdates!

Securities Disclosure: I, Georgia Williams, hold no direct investment interest in any company mentioned in this article.


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