Why the World Really May End on August 2nd, 2011

July 15, 2011

Yesterday we looked at the possibility of severe economic and market troubles from the European debt crisis.

Just as serious as the European crisis is the American debt limit crisis. A visionary thinker who I respect, Richard Worzel,  wrote a blog about the America debt crisis and how harmful it will be if a solution is not negotiated in time. Why the World Really May End on August 2nd, 2011.

From the blog posting yesterday I received questions from people saying thanks for the warning but what should we do about it?

This is where the information that Richard shares with us becomes very important. The blog was written earlier this month and Richard gave us some sign posts to watch in terms of the situation becoming worse. The events he mentions in the article have come to pass and in fact the red alert lights and the sirens are now turned on. Today this was confirmed by a warning that the US economy may be downgraded by the bond rating agencies. Dollar dithers as S&P threatens to downgrade U.S.

To update the current situation Richard is recommending where investors should be right now, very cautious.  Sell almost all  investments, except two – one in a precious metals fund, and one in a developing markets fund, and consider selling those next week if things don’t improve. Hold the proceeds in C$ cash,  not money market funds. If things continue to get worse and still no deal is done, it becomes more difficult. “I hate like hell to buy gold because I don’t even pretend to understand it, but the right move might be to resort to that.” But my first step is to divorce myself from market movements.

“People seem to think that Treasuries are strong because Congress will settle this issue. I think they’re wrong. Treasuries are strong because people are bailing on Europe, and there’s nowhere else that’s big enough to hold the refugee funds. This is skewing the markets so that things look better than they really are. But then, that’s just my opinion.”

Here are the recommendation that Richard made to help you protect your investments against further crisis. I have started the article excerpt at the point where Richard describes his investment strategy for times like this. As we saw the risks in Europe yesterday and the current ones in the US  you would be better off having missed a small market rally than being caught up in a major market downturn.

I think we are in for a long period of stagnant economic growth. If this is accompanied with a declining stock market like the graph above from we could be in for a lost decade similar to Japan’s.

Why the World Really May End on August 2nd, 2011

“So, what should we do about it? If the situation is as bad as you say, what’s the answer?”

Now we come to the reason for this blog: to offer some thoughts about what individuals should do to prepare for this possible black swan event.

The first thing to do is to hope that the participants are more intelligent than I give them credit for, and resolve this issue quickly, before they spook the markets or the rating agencies. If they wait too long, it may be too late, so August 2nd (or sometime that week) may be the outside deadline; the markets might panic before than. And writing to your Congresscritter wouldn’t hurt. Tell them that Congress & the president need to come up with a credible plan for reducing the deficit through painful spending cuts, tax increases, and especially through reductions to Social Security & Medicare entitlements, but that not raising the debt ceiling is not a legitimate negotiating tactic.

Next, watch the news for developments. Assuming that we can’t influence the participants (and they seem impervious to argument no matter who offers it), then you need to prepare yourself for the worst. You needn’t do it all at once, but make sure you stay ahead of the market’s perception of a crisis. And this is where systematic risk management comes into play.

In this situation, we are running two opposing kinds of risk: the risk that there will be a panic, market collapse, and massive recession or depression; and the risk that the U.S. won’t default, that a crisis will be avoided, and the markets will continue to advance. Let me deal with the second risk first.

If a crisis is averted, and the world carries on with business as usual (which is what I devoutly hope will happen), then the market will carry on as if nothing important happened. As the stock market has been rising of late, it’s possible that if you sold holdings in advance of a possible crisis, you could forego potential capital gains by liquidating your holdings. This is a potential opportunity cost, but not a large risk. Suppose the S&P 500 were to regain its previous 2008 high before you could manage to buy back into the market. This means it would have to run up by about 16% in a very short period of time. So, on the extreme high end of things, the second risk is that you might forego about a 16% gain from where we are today – and that’s assuming that the market keeps going up, and actually goes up much faster than it has of late. I think this is highly unlikely, but let’s leave it at that: the risk of missing an upside move by the markets is foregoing a 16% increase in your portfolio.

The Default Risk

Now let’s consider the first risk: that, intentionally or not, by August 2nd or somewhat before or after, the U.S. government defaults on its obligations, and that triggers a panic. What would be the financial risk if you don’t prepare for that possibility?

Well, first, how far might the market fall? In the market panic of 2008, the S&P 500 fell more about 54% from its October 4th high. The stock market crash of 1929 was slightly worse, with the Dow Jones Industrial Index (“DJII”) falling on the order of 58%.

But the initial market crash of 1929 is not the biggest risk; the potential for a prolonged severe recession or depression is. Indeed, the stock market decline from 1930 to 1932 was actually worse than the crash of 1929, with the DJII falling 79% from the market low of 1929 to the market bottom in 1932. All told, from the 1929 high to the 1932 low, the DJII lost an incredible 89% in value. And that is, in my opinion, the comparable risk investors run from a potential default, aside from any economic damage they might incur, such as losing their income or their home.

So, now we come to the issue of risk assessment: Which is the greater risk? Missing out on a potential 16% investment gain from here, or losing 89% of the value of your current portfolio from here, plus experiencing significant economic suffering? Remember that the markets are largely ignoring the closed-door discussions on raising the debt ceiling, so that if a deal is announced, it is unlikely that the stock market will blast off to that 16% gain in a short period of time, whereas if a default occurs, everyone will thunder for the exits at the same time. In my mind, there is no comparison: it is far riskier to ignore the potential for a default than it is to forego the potential for gain.

So What Actions Should You Take to Prepare?

If you concur with my assessment, what do you sell, what do you buy, and how do you prepare? I’d start by selling investments that have done well for you, but may have limited upside from here. You can always reinvest later if the crisis passes. If the days tick by, and there is still no word of settlement, I’d start selling more earnestly, including things that perhaps you don’t feel have done as well as they should. Remember that the rating agencies have warned that they are expecting to see a settlement by the middle of July. If no such signals emerge, they may start being more vocal, and the markets may become more unsettled.

If, by the third week of July, there is no sign of a settlement, and the two sides continue to say they are deadlocked, it’s time to take serious defensive action. Sell any investment that is not a disaster scenario holding. Perhaps even sell money market funds to hold cash. And check the terms and conditions on your financial accounts. Following the banking crisis of the Great Depression, financial institutions added clauses that give them the option to require 3-5 day’s notice of a withdrawal. Just because they have waived that requirement for almost 80 years doesn’t mean that it’s not there, so check with your banker or broker.

In the extreme, if it seems likely that a disaster is going to happen, think about what you think will hold its value. This starts with gold & precious metals, but also think about how you want to hold it. If you have investments in a mutual fund that invests in precious metals, and the company that runs that fund goes bankrupt, what will the value of your holding be? Cash is likely to be worth having, or being able to get hold of quickly – but who’s cash? Do you want US dollars? And always keep in mind safety. Do you really want to have bunches of cash under your mattress? What about the risk of fire or theft? How do you want to deal with that? These are issues that deserve some serious consideration.

And if a deal is struck “at the last minute” (whenever that might be), and there is no default, and no run on the markets, then what? Then you take a long look at the risks as they are at that time, and, if you’re convinced that the risks are now on the upside (i.e., that you might lose more by missing a major market advance than remaining on defense), then unwind your defensive positions, and go back to your investments.

If I’m overreacting to the potential risks, and life goes on as usual instead, it will have cost you some money in transaction costs, and you might possibly forego some upside on your investments. If I’m correct in my assessment of the risks, then taking a defensive position may make the difference between financial survival or not.

And, for the record, I sincerely hope a deal is struck. I may wind up looking foolish, rather like Chicken Little screaming that the sky is falling, but I would prefer that result to the horrors of being proven right. If it’s a choice between pride and survival, I’ll pick survival. But I’d be prepared for either one.

by futurist Richard Worzel, C.F.A.

I would like to thanks Richard for allowing me to use this excerpt from his blog. I would also urge you to check out Richards website for lots of other valuable tools to help you protect your investments.

Please member this advice may not be appropriate for your investment situation and your should always consult with your financial advisor before taking any investment action.

Bill Tufts

Fair Pensions For All

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