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Preparing For The Next Market Collapse

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Preparing For The Next Market Collapse

Summary

  • About two-thirds of Americans anticipate another financial crisis.

  • More are worried about a market crisis than are prepared for one.

  • Here is what works and what doesn't in a total market collapse.

It is an uncertain world and I want to be prepared

According to recent survey data from Northwestern Mutual, 67% of Americans believe that over time, there likely will be more financial crises. However, are these Americans prepared for the next one? A market collapse to be a possibility that many investors are vaguely aware of, but fewer have taken concrete steps to plan for. This is not something that I specifically expect and it is certainly not something that I hope for. It is something that I insure against in a prudent, moderate way.



What doesn't work: using data points from functional markets to model dysfunctional markets


How will specific investment ideas perform in a total market collapse? No one really knows. In many ways, 5% market corrections are substantively different than one tenth 50% moves. While the one is unlikely to meaningfully change corporate events, the latter will probably impact all corporate events. Regardless of contractual language, a massive market collapse will be material and adverse to nearly everything in the corporate world. Predicting and modeling collapse scenarios by linearly extrapolating from more modest price moves during market equilibrium is probably futile.

What doesn't work: relying on contractual obligations, previous financing commitments, and reputational costs of counterparties

During market disequilibrium, everything changes. Corporate behavior changes include companies' failing to get financing, failing to honor their legal duties, and changing their strategies to protect themselves. In each case, boards and managements are willing to accept more reputational costs in order to protect themselves.

What doesn't work: risk models

Value at risk/VaR and other Greek-based risk models fail. Most financial risk models will not be able to correctly measure the risk of loss during events that are materially different from the recent time periods used to build the VaR models' assumptions. Arithmetically hedging bad investment ideas will fail in more ways than could be previously contemplated. For example, if one looks as the loosely defined "arbitrage" in "merger arbitrage" and "convertible arbitrage" funds in 2008-2009, the long parts of their portfolios often dropped precipitously. But there was also forced covering in short positions as funds with high cross ownership covered positions in order to meet redemptions. One long-biased fund was having a sensationally good 2008 until its relatively loose redemption terms caused massive redemptions to meet limited partners' own withdrawals. Investors sought liquidity anywhere that they could find it with little regard for price.





What works: Sizing Discipline and Cash

Position Sizing


Ordinary opportunity sets should lead to only ordinary position sizing, leaving extraordinarily large positions for only the rarest of opportunities. At a one percent position, one could conceivably find subsequent risk:reward opportunities to double down three times and still have a statistically diversified portfolio. Hyper-diversification accomplishes very little, but a dozen truly uncorrelated positions accomplishes much of what correlation can offer. However, if one starts with a 5% position and doubles it three times on apparently better subsequent entry points, one is left with an over-concentrated or overleveraged portfolio.

When everything is going horribly wrong, the comparative advantage of being more liquid than your marginal counterparty becomes extreme. So, while I do not know what the right amount of cash is, I am certain that it is better to have more. You should have more than whomever you are trading against when nothing is working in the markets. How much is that? I currently have 25% of my assets in easily accessible cash and am glad that I do. My percentage might be too low but I am virtually certain that it is not too high. Whatever opportunity cost that I pay in terms of diminished return can be quickly recouped during the next market collapse.

Cash


Cash has other virtues. Instead of buying real estate with cash, my local mortgage broker got me a tax-efficient mortgage that costs 2% before taxes (and less on an after tax net basis). This allows me to build up a larger pile of cash on the sidelines to use opportunistically. I have hundreds of separate deposit accounts, most with balances beneath the $250,000 deposit insurance cap. I keep these accounts in institutions with diverse geographies and regulatory jurisdictions. Most are at institutions that have equity options attached to their deposits in the form of potential future mutual conversions. On top of cash available for seizing opportunistic investments, everyone should have at least six months of living expenses (twelve is better) in a separate account. This takes away any short-term pressure from potentially losing jobs.

What works: Backing up your backup plan

Service Providers


Investors should probably broaden their concept of backup plans. Clearly, there should be institutional redundancy. For example, if there is a crisis at your prime broker, you should have a dual prime or backup prime ready to take over. Securities Investor Protection Corporation/SIPC protects against the loss of cash and securities including such as stocks and bonds that are held by a customer at a financially-troubled SIPC-member brokerage firm. However, insurance claims can take months during which time you could be in immense professional or personal trouble.

Information Technology

There should also be redundancy in your information technology. Redundant servers in separate, safe locations can protect data. Also, crucial data should be backed up on computers without any internet connectivity. The added step of transferring data without connectivity is a hassle, but can make data much safer from attack.

Electronic vs. Physical Assets

What percentage of one's assets should be electronic and what percentage should be physical? While I do not know the right answer and while it certainly varies from person to person, having less than 10% in either electronic or physical assets strikes me as an extreme answer. With proper security measures, it might make sense to own some physical currency and stock certificates so that all of your financial assets are not reachable only electronically. Land, especially arable land, and the tools to work it, can also add redundancy to electronic assets during a market collapse.

What works: Redundant skills as well as redundant stuff

Professional Diversification


Within one's professional life, it can be lucrative and useful to have extreme specialization. However, it is also wise to nurture skillsets outside of one's specific specialty. Far short of a total market collapse, the 2008 financial crisis led to extreme new rules on short-selling, for example, that made some investment strategies impossible. Only with the skillset that allows you to react nimbly can you avoid professional paralysis in a total market collapse. What other relevant professional roles can you fill? What other professions might be available on a short-term basis?

Trade Skills

Maybe, the answer will be that no professions are needed over the short- to medium-term. It could be that the top of the professional food chain is demoted straight to the bottom in a total market collapse. What then? A second layer of redundant skills that may be worthwhile would be to have a basic trade that one can offer. In many potential natural and man-made disasters, the role of arbitrageur will not be what it once was. Fine. But I still want to be useful and relevant to my society and my family. So it is worth having some specific trade skills.

Primitive Skills

In a total market collapse, there could be a period of time in which neither professional nor trade skills are in demand. Thus, one should have the skills as well as the stuff for basic survival. Yes, one should buy when there is blood in the streets, but that old aphorism is hardly useful if the blood in the streets is yours. So, it is worth having a full range of options for self-insuring everything that insurance companies cannot insure, from all of the basic life needs to physical security, to the skillsets necessary to function in a crisis.

The Jade Turtle

Singapore is one of my favorite countries in the world. Its founder, Lee Kuan Yew is one of my heroes. It ranks second in the world in the 2015 Index of Economic Freedoms. But it is also located in a tough neighborhood. When one of their senior intelligence officers went looking for advice on securing their most important state secrets, he reached out to his counterpart in Israel for help. He invited the Israeli to visit to see how their security could be improved.

The Israeli first wanted to know the number of locations at which information is stored. "One" said the Singapore officer. There is a single location that is so secure that it requires no redundancy. Everything is there because it has the most sophisticated, modern surveillance equipment available. In fact, each night, the Singaporean officer personally checked on his most secure site. He trusts it with his most prize possession, an ancient jade turtle statue that has been passed down to him through generations of his family. It was kept behind every type of security apparatus available within a safe in the innermost part of the fortification.



He was suspicious of the need for redundancy, but asked his Israeli guest to show him the weakness of the facility, and the Singapore government will make whatever changes are needed. Two days later, he received a carefully wrapped package containing his jade turtle. The Israeli had made his point as clearly as it could be made. After that, Singapore always had a backup plan.

Conclusion

It might sound overly defensive or even paranoid to have a fully functioning plan in place for surviving a total market collapse during a period of relative peace and prosperity. It certainly is a comfort to know that one's business and one's family are well prepared to survive anything that could happen in the markets. But a mentality that focuses on safety in all environments, including in a collapse, can also be a strong offensive tool. If you are maximally prepared with redundant plans for all eventualities, then there is actually much less scrambling around to do in routine crises. Everyone else might be literally or figuratively flailing around in the dark. But you will be cheerfully prepared for everything, including prepared for scooping up what will be plentiful bargains.

Additional disclosure:
Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

Πηγή: seekingalpha.com

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