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Preparing for Economic Collapse

A Bear Awaits

Written by Briton Ryle
Posted July 29, 2014

With the U.S. stock market well into its sixth consecutive year of gains since bottoming in March of 2009, the chance of another collapse increases with each passing day. So do the number of doomsday predictions.

Investors, therefore, need to be cautious of two things… the increased chance of a correction, and the increased talk of a correction. Both increases – the increase of chance and the increase of talk – can be dangerous.

While the increased chance of a correction can rob us of the profits we have already made, the increased talk of a correction can rob us of future profits we could be making. It would be terribly unwise to count on one outcome alone.

Let us first consider the arguments for each outcome, and then formulate a strategy that would cover both.

The Case for a Collapse

Since the U.S. stock market bottomed out in March of 2009, the Dow Jones Industrial Average of 30 U.S. blue chip companies is up 135%, the S&P 500 broader market index is up 163%, the Russell 2000 index of small caps is up 195%, and the Nasdaq index of tech companies is up 219%. That, my friends, is a bull in full charge.

But every bull ultimately collapses, which is precisely what renowned market analysts Marc Faber and Mark Cook – the Marks of Doom – are calling for.

Appearing on CNBC yesterday, Marc Faber reiterated his call for a stock market correction within the next few months. The well-respected fund manager of over 40 years, with a PhD in economics from the University of Zurich, accurately called the tech bubble burst of the early 2000’s, the housing market collapse of 2007-08, and the subsequent market meltdown it triggered.

Faber sees the current 5+ years bull market as climaxing at a new high within the next two months, and then plunging 20-30% in very quick order.

For his part, Mark Cook, “a veteran investor included in Jack Schwager’s best-selling book, Stock Market Wizards and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble,” informs CBS MarketWatch.

His “Cook Cumulative Tick” indicator, which Cook created in 1986 to measure the relationship between the movement of NYSE trading ticks and stock prices, accurately warned of the stock market crashes of 1987, 2000, and 2007, and also identified the beginning of this latest bull market in April of 2009.

“There have been only two instances when the NYSE Tick and stock prices diverged radically, and that was in the first quarter of 2000 and the third quarter of 2007,” Cook points to the accuracy of his proprietary indicator. “The third time was April of 2014.”

This means we should soon see a correction similar in magnitude to the collapse of 2000 in which the S&P 500 fell 49% from 1,525 in September 2000 to 775 by October 2002, and to the crash of 2008 in which the broader index fell 56% from 1,560 in October 2008 to 675 in March 2009.

Moreover, Cook warns this time around could be even worse. “Every rally aborts before the previous high, and every decline penetrates and accelerates below the previous low,” the analyst reveals. Since the 2008 correction did indeed reach lower levels (675) than the prior correction (775), we might expect this upcoming correction to plunge below the last low (675) for a crash from current levels of at least 66%.

However, we must put these calls into perspective. Not all corrections hit lower lows. Neither the 2010 nor 2011 corrections breeched the 2009 correction low. Nor did the 2000 or 2008 corrections breech the 1996 correction low. Further still, the 2000 correction did not breach the corrective lows of 1997, 1996, nor 1994. And so on. The examples of corrections not breeching new lows are greater in number than the examples of those that did.

Expecting every new low be always be lower than the last would be like expecting each time it rains to rain more than the last time it rained. While that will be true some of the time, it will not be true all of the time, and we must not make a rule out of it.

It must also be noted that while Cook, Faber, Rubini and other well-known callers of market crashes have made accurate calls in the past, not all of their calls have been as reliable. If you call for rain every single day, you will be right every time it rains, but you will not be right every time you call.

The Case for a Continued Bull

When looking at previous market crash patterns, there is one pattern in particular that most doomers neglect to note… crashes do not happen when the government has the stimulus tap turned on. Only when the tap of cheap, easily-accessible money is in the off position do crashes happen.

As noted in the graph below comparing U.S. interest rates (black) to the Dow Jones index (blue), the last two major crashes occurred when interest rates were high (red), while low interest rates only fuelled the market higher (green).

Interest rates vs dow jones

Source: TradingEconomics.com

While smaller magnitude corrections do take place even when monetary policy is highly accommodative, such as the 18% correction of 2011 dotted above (blue), such corrections are never severe, nor do they turn into bear markets when money is cheap.

Thus, while the markets are always susceptible to pull-backs, we must factor-in all underlying conditions, including the Federal Reserve’s commitment to low interest rates. Previous patterns have shown that whenever the market runs into trouble, the government always steps-in with bags of stimulus money to prop it back up again.

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Being Prepared

On these two patterns we can be sure: corrections can happen at any time, but crashes happen only when the Fed is out of the picture. Investors must therefore be prepared for the next correction, but must not exit the market completely in anticipation of a crash.

How? For do-it-yourselfers, a simple and effective method is dollar-cost averaging, using the following steps:

• Allot a certain amount of cash to a stock or fund, investing 70% into the stock while keeping 30% in cash (or other percentage split you are comfortable with depending on your measure of current market risk).

• When the stock is up, sell some shares. When the stock is down, buy some shares. In this way you would be moving money back and forth between the stock portion to the cash portion, buying low and selling high in steps.

• To determine how much to buy or sell and when, simply add each stock’s value with its remaining unused cash that you allotted to it. Multiply the total value of stock plus cash by 70% (giving you the new stock investment) and 30% (giving you the new cash reserve).

Example: You allot $10,000 to the SPY (S&P 500 ETF), buying $7,000 worth of SPY and holding $3,000 in cash.

The SPY rises 5%. You now have $7,350 worth of stock, and still have the $3,000 in cash attached to it, for a total of $10,350. Multiplying the new total value of $10,350 by 70% gives you $7,245 to be invested in SPY, with the remaining $3,105 to be held in cash. Hence, as the stock price rises, you take a little off the stock and move it to cash.

Then the SPY then falls 5%. You now have $6,883 worth of stock, and still have $3,105 in cash for a total of $9,988. Multiplying this new total value by 70% give you $6,992 to be invested in SPY, with the remaining $2,996 to be held in cash. Hence, as the stock price falls, you move a little from cash back into the stock at a lower price.

SPY

In each case, adding the values of stock and cash, and then multiplying by your target percentage-split will determine how much to keep in stocks and how much to keep in cash at any given time.

With this procedure you will never get a margin call during a correction, for you will already have set aside the cash you need not only to shore-up the stock position but also to purchase more at cheaper prices. You can in this way take advantage of corrections, which are golden buying opportunities in disguise.

To optimize your portfolio’s performance, you could take all those cash portions set aside for each stock and store them in a bond fund, Treasury notes, or reliable dividend paying stock or fund. Just be sure not to take too much risk with these cash reserves, as you will be needing them for dollar-cost averaging your stock positions during corrections.

The key, then, is to be prepared for rain, but don’t abandon your fields and stay locked indoors. If we had obeyed the doom-sayers every time they called the end of the bull market, we would have missed out on years of profits.

Joseph Cafariello

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