I love the absurdity of the old Road Runner cartoons.
Besides some mindless childhood entertainment, there are some great lessons in there for adults. When one of Wile E. Coyote’s various schemes fails to play out, he’ll often simply chase the Road Runner right over a cliff.
The gag is that he doesn’t fall until he realizes he’s run off the cliff.
That’s a great way to think about economic policies and market sentiment. There may already be a danger out there, but until folks realize that we’ve already gone off the proverbial cliff, we’ll continue to think we’re on solid, high ground.
It’s not physics where there are laws with immediate consequences. In finance and investing, the consequences are usually delayed.
For instance, the Federal Reserve finally got off zero percent interest rates in December 2015. It’s been 17 months.
Typically, the actions of the Fed take 12-18 months before they’ve fully worked their way through the economy.
Yes, the rate hike was small. But there have been three of them now, and that’s a trend that could pose trouble. Higher interest rates cause marginal changes in how people decide to invest their wealth.
Even a decade ago, when short-term rates were 3-4 percent, you could get a decent, 5 percent return in a money market account. That kind of return is high enough to make any investor pause before investing in a risky stock. Today, with short-term rates still low, and cash-based investments yielding so little, stocks still look like the best game in town.
But stocks carry a risk of capital losses. In the post-financial crisis market, we’ve seen markets pull back around 10 percent at best before investors start to send shares meaningfully higher.
As a result, stocks have become overvalued. It doesn’t matter whether you use a metric like price to sales, price to book, or the classic price to earnings. The only other two times stocks have been this expensive on the whole have been the tech bubble and the housing bubble.
I don’t think we’re in bubble territory yet. There’s a psychological component to a bubble that “this time is different.” Individual stocks are still susceptible to steep selloffs — just witness the retail sector’s decline following disappointing holiday earnings.
What this does mean is that you need a way to quickly defend yourself against a broad market decline. Usually when stocks decline, a few different asset classes perform differently. While the playbook might be gathering dust, they’re still proven strategies.
First, when stocks decline, put premiums rise. I don’t want anyone to simply go out and short the market. That’s too risky. But periodically buying put options against the broad index is a simple, and inexpensive way to make some profits while waiting for the latest correction to work out. Right now, put option premiums against the overall market are generally cheap.
Cheap insurance might not always pay out — when you buy options, you’ll eventually lose all you sell in time premium. But a relatively well-timed put option trade can handily double even in one of today’s small 10 percent-type corrections.
Second, when stocks fall, market volatility rises. We’ve seen market volatility get absolutely crushed in recent years as investors have been making increasingly one-sided bets on the stock market rally going on forever. Traders loved volatility trades during the financial crisis, and since then that love has waned as it’s been an out-of-favor place to look for a trade.
With the market’s overall volatility index rating (VIX) under 13 as I write, against an average reading of 17-20, the VIX is at least 30 percent below its normal average. The only problem with volatility trades is the timing. It needs to be much more precise than a generic options trade, because volatility may be low, but it can make bigger moves in a short amount of time.
Holding volatility trades is like Wile E. Coyote buying an Acme product. It’ll probably blow up at some point.
Fortunately, there are better strategies for investors.
The third area that garners interest during a market selloff is gold. That’s not always the case. Typically, gold does better when the market is selling off for inflationary or geopolitical fears. In today’s environment, we could be seeing a bit of both perk up.
Furthermore, gold has been out of favor with investors since spiking to $1,900 per ounce back in 2011. What’s fundamentally changed about the economy in the past six years?
Only more debt.
Gold, which has no counterparty risk, is the anti-debt. It’s looking increasingly attractive as both a defensive way to protect against today’s high-priced markets as well as an offense for growing your wealth going forward.
Finally, and call me an optimist, but going long stocks is my favorite way to make money off a market decline. Stocks can take a long time to rise. And when they fall, months or years or gains can disappear in the space of a few days or even a few hours.
Buying during the fear of a further market correction is where the biggest gains are made.
The tough part? Seeing through the fear and looking beyond. After all, if stocks are expensive on average. A selloff might make them cheaper, but still not worth buying. However, since many individual stocks remain out of favor, there are plenty of buying opportunities today without waiting for a broad market decline.
Bottom line, investors have plenty of ways to protect themselves from today’s high-priced markets. They can simply bet against the index with shrewd options bets. Or bet on higher volatility. Or, for a geopolitical danger, buy gold. Finally, they can look ahead past the correction and look out for what’s likely to perform well over a longer timeframe.
However you prepare for a market danger, don’t take today’s high prices for granted.
Like Wile E. Coyote, it only takes a slight mental shift for today’s status quo to rapidly decline.
Make sure you’re protected.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.