How to Prepare Your Portfolio for the Next Market Mess
What happens if it all goes wrong? Investments designed to preserve your wealth in a stock-market downturn can help preserve your sanity too, allowing you to avoid dumping your favorite stocks as prices tumble.
But finding this market insurance has become harder, with Treasurys and perhaps even the dollar no longer offering the protection they used to. No wonder gold is up so much.
The basic problem: Much of the insurance provided by any investment depends on how other people react. A secondary issue that’s particularly important for Treasurys is the new era of inflation sensitivity.
The selloff since the S&P 500 peaked in mid-February is illustrative of what’s meant to happen, and what’s not. Treasurys did what they are supposed to do, and profited as stocks fell. The dollar didn’t, falling with stocks. Gold did both, initially dropping as stocks sold off, then rising fast.
Of course, a few weeks’ returns are mostly meaningless. Instead, I’ll look at how the protection offered by Treasurys has shifted in recent years, before discussing the dollar and gold:
Treasurys used to be the have-your-cake-and-eat-it-too investment, providing what amounted to free insurance against stock-price falls from the late 1990s onward. When times were good, bond yields declined, so prices rose. When times were bad, the Federal Reserve cut rates, so bond prices rose even more. In market panics traders piled into Treasurys, so bond prices rose. The icing on the cake was that over short periods bond yields tended to rise and fall with stock prices, so Treasurys helped make a stock portfolio less volatile without giving up much in the way of return.
The move from a time when investors could ignore inflation to one where inflation is a constant pressure has changed how Treasurys and stocks behave. Bond yields no longer reliably rise and fall with stock prices, because inflation fears can push yields up and stocks down at the same time. As they learned in 2022, investors can lose on their Treasurys even when stocks are falling.
Treasury yields don’t reliably move in the opposite way to stocks, as they did from the 1970s to the late 1990s. But they can no longer be relied on to provide a sweet treat when stocks drop.
This isn’t to say Treasurys are useless. They once again offer a reasonable yield, 4.3% on the 10-year, and ought to do well in a panic, at least short of a 2020-style liquidation. It’s just that they can no longer be expected to provide either the long-term returns or the free short-term portfolio protection that once made them so tasty.
The dollar has a different problem, but the root cause is the same: It’s just too popular. Americans don’t tend to think of the dollar as an investment option, since it is just their currency. But it is merely the default—and may no longer be the right choice.
For a long time the greenback has provided a remarkable form of insurance dubbed the “dollar smile” by Stephen Jen, now chief executive of Eurizon SLJ Capital. In good times for the U.S. economy it strengthens as money flows in search of profits. In bad times for the U.S. economy it strengthens too, as money flows in search of America’s safe assets.
The first part has worked very well recently, but perhaps too well. Money has flooded in to such an extent that the dollar in January was the strongest against major trading partners, adjusted for inflation, since the 1985 Plaza Accord to weaken the currency. Foreign investors chose the U.S. because its economy was red hot and its market the home of the exciting Big Tech and artificial-intelligence stocks.
Will still more money arrive if there’s a downturn? The danger is that the “American exceptionalism” trade became so widespread—even before President Trump’s November victory gave it a final boost—that if the U.S. hits trouble money will leave, rather than seek safety.
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Normally when investors panic they repatriate much of the money they hold in stocks, offset by money going into the safety of Treasurys. Now there’s a lot more foreign money in U.S. stocks, and less U.S. money abroad to pull back.
Matt Smith, a fund manager at Ruffer, says: “Foreign money has poured in and allowed U.S. money to pour out into consumer spending and government borrowing.” When that goes into reverse, the dollar will find it harder to smile.
The talk from some in Trump’s team of using a putative “Mar-a-Lago Accord” to punish foreigners who hold dollars could deter some who would usually seek out dollars, too.
Gold has already been a big beneficiary. The price is up 50% in just over a year as investors bet on more buying by foreign central banks concerned about parking their money in dollars. This might be a problem. Unlike Treasurys and the dollar, gold ought to do well in a new era of inflationary pressure. But like Treasurys and the dollar, a lot of money has already poured in. How will it fare in a panic?
Gold gained a similar amount in the 12 months to March 2008, as fears of financial troubles rose. But when first Bear Stearns and then Lehman Brothers failed, gold prices crashed from above $1,000 an ounce to just over $700, as investors sold to pay off debt.
Cash is the safest of safe assets in the short run, and at the moment has a decent yield—but doesn’t go up in value when times are bad, so is more about timing the market than long-run investing.
When choosing a safe asset, it’s just as important to know who else owns it as to think about its fundamental properties. If they all sell in a panic, you’re stuck with something worth a lot less if you need to sell in a hurry. I still like Treasurys, and would have more cash than usual, but all the options are much less attractive than they used to be.
Write to James Mackintosh at james.mackintosh@wsj.com
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