[Editor’s note: the following is a cross post by Peter J. Tanous that originally appeared on CNBC.com]:
Stock market declines, especially the violent kind we refer to as “crashes,” are pretty hard to predict.
True, for every crash one or two visionaries emerge who called the market decline with unusual accuracy. In time, we generally conclude that these visionaries were more lucky than prescient, because there are no records of prognosticators who predict market crashes more than once.
But this time may be different.
The Federal Reserve has been propping up the stock market through its quantitative easing program that forced interest rates to all-time lows and drove investors out of bonds and into stocks.
But those days may be coming to an end.
For one, the Fed can’t keep printing money to buy U.S. bonds. Bond purchases by the Fed, with printed money, account for about three-quarters of all Treasury bond purchases resulting in a Federal Reserve balance sheet that exceeds $3.6 trillion.
One day, QE must come to an end.
Indeed, on June 19, 2013, Fed chairman Bernanke hinted that QE might slow from its recent pace.
The stock market reacted with a hefty decline of 2.5 percent on June 20. By June 24, the stock market had declined almost 5 percent in less than a week.
Now this isn’t a crash by any measure, but it might be a harbinger of things to come. Here’s where the predictability thesis come in.
We know that the market won’t like any reduction in Fed purchases. So what will happen when the Fed not only reduces its bond purchases, but stops them altogether? Hasn’t the market told us how it will react?
I think so. Moreover, QE is likely to end by December or early next year, so that gives us a projected timetable of coming events.
What’s an investor to do?
Most investors have substantial gains in 2013. Stock are up 17 percent through late August and investors are eager to protect their gains.
One obvious solution is to buy puts on the S&P 500 but this is costly protection. Better to buy out-of-the-money puts so that the protection covers only a major decline.
Even so, providing this kind of protection for the entire portfolio is too costly to be effective.
Another solution worth a close look is structured notes. Many banks and investment firms issue these securities that have multiple year durations.
In the simplest form, the investor trades some of the market upside for protection against downside risk. The notes come in Heinz 57 varieties and some are better than others, but definitely worth considering. Remember to consider the credit quality of the bank or investment firm issuing the note.
What about just selling out of the market and waiting out the crash? Here’s a reason not to do that: many professionals are predicting a correction in stock prices.
Stock crashes inevitably occur when least expected, and almost never when the pundits are predicting one. So buying some insurance may be the best bet, not getting out completely.
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