Last week in Are Stocks Starting to Get Spooky? we discussed that 2018 has ushered in a time of volatility in stocks not seen since the Financial Meltdown. Common sense should dictate that after nine years of steady gains in stocks, the end of the current bull market may be in sight. That’s why we need to develop alternative investments for an increasingly volatile stock market.
Let’s discuss stocks, and some of the alternatives you should consider at this point in the investment cycle.
LET’S START BY TALKING ABOUT STOCKS
Whenever a discussion of alternative investments comes up, stock market investors get defensive. Are you saying I should dump all of my stocks, and put all my money into alternative investments?
Nope. And nothing can be farther from the truth.
But it’s a fact that most investors are very heavily invested in stocks at market peaks. It’s not unusual to see investors holding 80%, 90%, or even 100% of their portfolios in stocks right now.
Typically, when we’re several years into a bull market, investors have long since forgotten the last market crash. They throw caution to the wind, and imagine they can get rich in a few years if they just stay “fully invested”.
That strategy makes sense when the stock market is running up. But at market peaks, it can be an unmitigated disaster.
For example, if you have 100% of your portfolio invested in stocks, and the market sustains a 50% decline, you’ll lose 50% of your portfolio. (In reality, most small investors will lose more, due to overaggressive investing.)
Unfortunately, most small investors can’t afford to take a 50% hit in their portfolios. Often when they do, they exit the market for several years, and don’t return until the next bull market is a few years old.
That’s a recipe for investment disaster. You take disproportionate hits when the market falls from its peak, but miss out on most of the gains when the next bull market returns.
The basic idea is always to be sure your investment level is commensurate with the risk involved in the market. Ironically, multiyear bull markets tend to be more risky, because the downside risk increases as prices move higher. Prolonged bear markets tend to be less risky, because price speculation is flushed out of the market.
With that in mind, you don’t need to dump stocks and move wholesale into alternatives. But you should begin reducing your stock holdings, and gradually move into alternatives.
Retain the stock positions that you feel most comfortable with, but sell off those that have not been doing well recently. After all, if they’re not doing well in an historic bull market, they’ll probably do worse in the subsequent bear market.
WHAT ABOUT BONDS
There’s something of a myth that bonds are countercyclical to stocks. That may have been true in the distant past, but certainly not in recent decades.
There’s a common element between stocks and bonds, and it’s interest rates.
Bonds move in inverse relation to interest rates. When interest rates rise, bond prices fall. When interest rates fall, bond prices rise. So it has been the general trend since the early 1980s, when interest rates went on a very long term decline.
But at the same time, so have stocks. In the super bull cycle, stock prices bottomed out in 1982, and have been charging forward ever since, albeit with a crash every few years.
The point is, since the early 1980s, stocks and bonds have been moving in tandem. They can no longer be considered mutually exclusive, therefore bonds are not really a counter investment to stocks.
Both have benefited from historically low interest rates. Just like bonds, stocks have risen over the years in response to lower interest rates. It’s based on the simple fact that low interest rates make stocks more attractive.
After all, if investors have a choice between a double-digit return on stocks, and a 0.25% return on a six-month CD, they’re going to invest in stocks.
The fly in the ointment however is rising interest rates, which is what we’re currently experiencing. Rising rates will not only depress bond prices, but eventually stock prices as well. As returns on safe, interest-bearing investments – like CDs and money market funds – increase, they compete with stocks for investor funds. Many investors, particularly retirees, prefer interest-bearing securities. That means rising rates can hurt stocks, just as they will bonds.
But in such an environment, bonds won’t be counter cyclical investments to stocks. As interest rates rise, bond prices fall, causing investors to lose money on their principal investment.
In the past 30 or 40 years, bonds are no longer mutually exclusive to stocks. The same factor – rising interest rates – will cause both to drop in value.
CASH AND CASH EQUIVALENTS
In some respects, cash and cash equivalents are the safest investments to hold when stocks and bonds are declining. They may not pay much in interest, certainly not in recent years, but they do one thing that investors absolutely require in bear markets: they preserve capital.
Even though returns on cash and cash equivalents are not impressive, it’s their defensive capability that you should be interested in. If you can simply preserve capital during a prolonged bear market, you will come out ahead. Most all investors will lose at least some money in a prolonged bear market. Those who are most heavily invested, will lose the most.
But by holding at least some of your money in cash and cash equivalents, you remove it from loss.
It’s actually a more aggressive strategy than it seems on the surface. By building up cash reserves prior to, and during, a bear market in stocks, you will build up your capital to purchase stocks once the market turns positive after the fall.
So while cash may seem boring, marked by low returns, take the longer-term view. You’re not looking for returns, but instead preparing for the next bull market.
If that’s all cash does, it’s done its job.
REAL ESTATE INVESTMENTS
Real estate isn’t a precise countercyclical investment to stocks, but it can be a profitable way to move into a long-term alternative to stocks.
Holding one or more individual pieces of real estate can get the job done. A well purchased, well-managed rental property can be profitable regardless of what the economy or the financial markets are doing.
Not everyone however has the bankroll or the stomach for individual real estate. For such investors, you can also invest in real estate investment trusts, or REITs. These are essentially mutual funds that hold portfolios of income producing properties. It can be retail space, industrial space, warehouse space, or apartment buildings. REITs today are setup much like the various stock sector funds, in that you can choose specifically what types of property you want to invest in.
The returns on REITs can be attractive, not the least of which because 90% of their income must be returned to investors as dividends. That can be a welcome cash flow in a bear market in financial assets.
The website Reit.com provides data showing that REITs outperformed stocks from 1978 through 2016, with an average annual rate of return of 12.87%, to 11.64% for stocks. What’s more, they also show that REITs heavily outperformed stocks during the Financial Meltdown.
Moving some money from stocks into REITs can be a smart move at the peak of a bull market in stocks.
One of the basic reasons why investors continue to hold gold and silver is precisely because they tend to perform best when other investments are performing at their worst. While many mainstream investment experts point to decades like the 1980s and 1990s, when precious metals lagged well behind stocks, there are other time frames when the results are the exact opposite.
Gold experienced its best runs during the 1970s, and during the time frame from 1999 to 2011, when other investments, particularly stocks, did particularly poorly. In a way, that makes them the ultimate countercyclical investment.
Precious metals, particularly gold, are an excellent play on financial and political instability. During times of financial and political crisis, Gold has its best performance. For this reason, it’s often been considered to be portfolio insurance. It’s particularly popular among sophisticated international investors, which is why small investors should take notice.
There are two ways to hold precious metals: owning the metals themselves, or opening a Gold IRA.
Physical metals are available at Treasury Vault, and can be purchased in fractionals, rounds and bars, as well as certified gold cards. These are easy and convenient ways to hold the actual metal.
Alternatively, you can open a Gold IRA, where you can hold the metals as investment protection for your retirement assets.
Gold IRAs are self-directed, and can also be used to hold foreign currencies.
Speaking of which…
Few investors think of foreign currencies as alternative investments. But in a general financial market decline, all types of assets can rise in the face of uncertain circumstances.
Every currency is a reflection of the country that issues it. It’s a fact that during serious economic meltdowns, some countries perform better than others. For example, in an attempt to become more economically competitive, countries like the United States or the European Union may weaken their currencies in order to attract foreign investment.
By contrast, smaller countries may have more stable currencies – that appreciate against the US dollar – because their economies prove to be recession resistant. This is often true if for no other reason than that developing economies are already operating a lower levels, and their currencies are relatively cheap in the current market.
Those are exactly the types of currencies that could prove to be solid alternatives in the general financial market blowout. A small position held in developing country currencies, like the Vietnamese Dong, or the Iraqi Dinar, could increase in value in an asymmetric market environment.
A small position in one or more of these exotic currencies could prove to be a winning position.
If you’re worried about the direction of the financial markets – and you should be as 2018 unfolds – hold on to your best performing stocks. But move increasing amounts of money into cash, REITs, precious metals, and foreign currencies. They may prove to be the best investments you own in the next few years.