When the music stops: Are you prepared for negative surprises?
Markets hum along to their own beat and rhythm, until they don’t. From time to time, the music suddenly stops. It might be fears of a trade war that trigger a sudden silence and jarring price dislocations. It might be Korea, protests in Jerusalem, or bankruptcy fears in China. We typically get no advance warning, and never know how long the silence will last. But we do know this: at some point, the music will stop. Will you be ready, or have to scramble to find a chair?
As unlikely as it sounds Korea and Iran may have no nuclear war power by 2020. The Korean peninsula could be cleaned out of weapons by an international team in exchange for economic stability. Iran may be forced through economic stress and popular dissent to abandon nuclear capability. It could really happen. Or it could completely unravel into a situation that’s far more precarious than what we face today.
Angst over tariffs, mid-term elections, congressional deadlock, a policy reversal by the Fed, a terror attack or natural disaster, a cyber attack on voting systems, utilities or air traffic control would make big headlines. A plain old recession could happen too.
With so many ways to ruin the party, and no way to know when it might happen, what can investors do to protect themselves?
Diversification, planning, and a little arithmetic make a big difference.
Too much of any single asset class opens a portfolio to unpleasant, concentrated shocks when conditions change. Diversifying across many asset classes typically softens the impact related to any single economic, political or market change.
Stocks typically fall when the music stops (but not always, and sometimes only for a couple of hours or days). The impact on bonds can be even murkier. Interest rate changes are very difficult to predict, but one can easily discern the impact on bond values in response to hypothetical future rates. Interest rate and price always move in opposite directions; the math is formulaic. For instance, if yields on benchmark 10 year treasury bonds rise by 2 percent, the value of existing 10 year bonds will fall by 15%.
With this in mind, any portfolio can and should undergo regular stress tests for changing interest rate, stock market, currency and commodity scenarios. Testing what-if possibilities related to interest rates can be especially helpful in determining asset allocations that are consistent with your goals and risk tolerance. It’s also helpful to look at long term performance of bonds to understand how current conditions resemble or depart from historical trends. Before you make a broad investment decision, check to see that the bond market and the stock market are telling the same story. Check historical correlations between asset classes for some guidance.
These analytics won’t answer every one of our questions about an unknowable future, but taken together they may help to tune your portfolio in anticipation of the change on the horizon. And remember, stress testing only works when it’s proactive – don’t wait until the music stops.
– Max Osbon