You often hear about investing for diversity. You also hear that precious metals, soft commodities, emerging market stocks, US Treasuries (or rare stamps, timber lands, or whatever) are good investments because they rally in different markets than ordinary stocks.
During the good times, that’s true, for all those alternatives. During bad times, it’s mostly true.
During really bad times, it’s not true.
But how can that be?
Shouldn’t a stash of gold coins hugely outperform if paper assets are on their way to zero? Shouldn’t Treasury bonds be the beneficiaries of a huge bid by investors seeking safety? Shouldn’t those ag commodities protect you from a worldwide collapse of currencies and capital markets?
Well, sort of.
If you want to outperform the asset class that is doing the worst (epicenter of the meltdown), just being invested in anything else will help you suffer less. Note that I said less, not avoid suffering.
However, when a meltdown is going on, it’s axiomatic that you really can’t get a bid on the asset class that is tanking. So what do you do if you own a big slug of that asset, and your counterparties’ margin clerks are on the line demanding cash?
Answer: You sell what you can. In other words, selling begets selling, and not just in the class of securities where the problem started. Often, it’s the classes of investment where people have profits that are the first to go in a panic. That more or less guarantees that everything else heads south at the same time one big market is getting hammered.
Voila! That’s correlation. You may have spent years watching your gold coins or Treasury bonds appreciate on days the stock market dipped, and of course days or even weeks when the stock market rallied and you could just watch. But when the fit hits the shan, enough of your fellow gold holders and Treasury buffs are looking to raise cash that they begin selling those.
I’ll let you in on one of my favorite sources of information. Has been for years.
That’s the mother of all debt surveys, and it tells us how much debt there is, be it car loans, muni bonds or private bank “lower floater” derivative bonds. It’s the source for almost every doom and gloom report you’ll see from the gold-touting sites.
And the story the Z.1 report is telling is not pretty. Page three of the summary reports tells us the total debt outstanding for various borrower classes. While perusing the top of the chart to get the column headers in mind, just take notice that with our GDP running between $1.6 and $1.7 trillion back in 1975, domestic financial debt totaled $260 billion (less than 20% of GDP). For comparison purposes, household and business sectors were each about half of GDP, and Federal debt was just over 25%
Now, scanning down to last quarter, our $14.7 trillion GDP economy is somehow going to pay debt service on $13.5 trillion in household debt, $10.9 trillion in business debt, and $8.2 trillion of Federal debt. But as outrageous as those are, it’s the financials that take the prize. They have been shrinking their exposure for the last six quarters (take a bow, taxpayers and savers, for bailing out the banks and giving up your CD interest to rescue them). But they still have nearly $15 trillion in debt.
So, when a panic downturn comes in any big market, you can bet short odds and win if you bet that at least some domestic financials are holding large chunks of that market, and they are holding it with borrowed money. Throw in the fact that virtually every financial uses swaps these days to make all their liabilities into short-term debt, and you have frequent rollovers or resets. Every time that rate resets or that debt rolls over, there’s another opportunity for the holders of that debt to look at the balance sheet, and the assets the financial company holds. That’s when the financials will be selling assets – any assets.
Welcome to the world of correlation that doesn’t show in the bull market, but can kill you in the bear.
PS I just got back to even in my short-biased long Treasury ETF’s. I still think when we look back years from now, it will look like 2.5% was basically the low in rates for the 10-year T-Note. Can Bernanke screw me again in this position? Of course.
But he’ll be just as effective as King Canute was with the tide at the long end of the curve.