The Next Financial Crisis

Positioning Your Investments for
What’s Ahead, Not What’s Behind

“The financial crisis is dead and gone, time to bet on banks,” blared a headline on Yahoo Finance. It appeared on Sep 11, 2014 – 5 ½ years after financial stocks bottomed.

The timing of such a pronouncement is curious. Let’s go back to January 2009. That was two months before the financial sector and the broad market both finally bottomed – after being devastated by the financial crisis.

At that time, I noted in Independent Living, “Financials made up 22% of the S&P 500 at the beginning of 2007. Having plunged 80% from their 2007 highs to their 2008 lows, they now comprise just 13% of the market.”

Well before the financial crisis unfolded, we had cautioned against owning stock market index funds. We warned they were too heavily weighted toward the vulnerable financial sector. But in January 2009, I wrote, “Today we find ourselves at a rare moment in history when every sector in every stock market around the world has been marked down. So at last, we have a valid reason and a prime opportunity to buy broad stock market index funds.”

Timing the Market May Be Impossible,
But Timing Your Purchases Well Isn’t

We don’t claim to pick exact tops and bottoms – and urge you to be suspicious of anyone who says that they can. We look for assets selling at attractive valuations. And stay on the sidelines or sell when they appear overvalued.

You could have bet on a quality bank like Wells Fargo (WFC) in late 2008. It traded for less than $20 a share in early 2009 when it got marked down to under $10. Top Wells Fargo shareholder Warren Buffett was buying aggressively in his favorite companies during this crisis period. You could have bought Wells Fargo in 2010 or 2011 when share prices were consolidating. You even could have bought the stock when it broke out to new all-time highs in 2013.

Drilling Down into Market’s Sector Composition
Reveals Where Value Can Still Be Found

The financial sector as a percentage of the S&P 500 is now back above 16% – above its long-term average.

Now is not the ideal time to be investing in the financial sector. I say this in spite of the popular idea that the banking system’s problems have been permanently solved by the U.S. Treasury Department and Federal Reserve. Not so.

Financials may never get back up to their 2007 peaks versus other sectors precisely because the government is paying closer attention. Regulators are now keen on preventing bank balance sheet excesses. What they don’t say is that many banks’ balance sheets are impaired right now. Other banks are highly vulnerable to rising rates or an economic recession.

The sectors that have the heaviest weightings in the S&P 500 have run up the most since 2009. And they sport the loftiest valuations. If you’re a value investor, now isn’t an opportune time to be loading up on them. That includes financials, technology, healthcare, or consumer discretionary.

Healthcare may still be a good long-term place to be. We’ve written about the favorable demographic trends behind rising medical spending. But the herd has already caught on. They’ve bid up share prices in this sector (and especially in the biotechnology sub-sector) to lofty heights.

Sector Investing vs. Broad Market Investing:
What You Need to Know

The sectors that have been given short shrift of late are the ones with the highest dividend yields and the most attractive valuations. They include energy, materials, utilities, and telecommunications. Materials and utilities both trade well below their historic stock market weightings. Combined, they come to less than 7% of the S&P 500. Yet the other 93% of the market wouldn’t exist without electricity and basic materials. It’s a good time to focus on the under-appreciated suppliers of the most essential things in our economy. It’s not an ideal time to pursue broad market indexing.

Something like an S&P 500 index fund employs a passive approach to portfolio construction. It weights its holdings based on market capitalization.
The biggest, most heavily bid up sectors get the most weighting. Thus, stock market index funds are overexposed to the most overextended sectors at market tops.

You don’t want to be stuck in broad market index funds during a bear market. Hedge funds and actively managed funds can raise cash to limit downside in down markets. But as we’ve noted many times, they tend to underperform lower-cost index funds over time. The longer the time period, the worse the average underperformance.

You can still take advantage of the efficiencies of index funds. And without committing to owning the whole stock market. There are sector index funds for every sector of the S&P 500 (and for dozens of sub-sectors).

There are also a number of global sector funds that own stocks in a given sector from around the world. Among them:

  • iShares Global Materials (MXI)
  • iShares Global Utilities (JXI)
  • iShares Global Energy (IXC)
  • iShares Global Telecom (IXP)

What’s Going on with Precious Metals?

At some point the premier place to be won’t be in any sectors of the stock market. It will be in physical precious metals.

Admittedly, it’s been a frustrating three years for precious metals investors since gold and silver prices reached a cyclical peak in 2011. The consolidation phase has extended further out in time than most analysts we follow had expected.

From August to mid September this year, normally a seasonally strong period for the metals, prices drifted toward the lower bounds of two-year trading ranges. The inability of the metals to rally despite favorable seasonality and political unrest in commodityproducing countries across the
Atlantic is concerning.

Is the latest price take-down the final dagger in the heart of the precious metals market? Or was it the last gasp of the price suppressors?

Our indicators continue to suggest that another run up in gold and silver to new highs still lies ahead. That doesn’t mean we won’t see more setbacks first. But it does mean that the 2011 highs probably weren’t the final, generational highs.

The markers of a “final” top like we saw in 1980 simply haven’t been seen yet. Silver hasn’t even broken out above the 1980 top near $50 per ounce yet! It only kissed it in late April 2011.

We also haven’t seen the ratio of the Dow Jones Industrials to gold get anywhere near as low as it did in 1980. The Dow:gold ratio hit 14:1 in September. A major move up in gold could bring the ratio all the way down to 1:1, where it got in 1980 and during the Great Depression.

The Dow:gold ratio may not get all the way down to 1:1. Even if it only got back to 4:1 at some point in your lifetime, you’d benefit handsomely by switching out of the Dow and into gold (and silver) at these levels.

Another financial crisis is coming. It may not be the banks that trigger it this time, but rather the government debt market.

In 1980, the U.S. government was in comparatively good financial shape. It had tax revenues of about $1 trillion against a national debt of $1 trillion.

Today annual tax revenues come in at about $2.5 trillion. But the national debt has exploded to $17.8 trillion. That’s just the official figure, which doesn’t include more than $100 trillion in unfunded liabilities.

Dollar Destruction

The vulnerabilities of the bond market have been masked over the past few years by the Fed’s Quantitative Easing and other interventions. The Fed has a seemingly unlimited appetite for U.S. Treasuries and an unlimited budget.

But if the Fed saves the bond market, it will come ultimately at the expense of the dollar.

Not even the almighty Fed can repeal supply and demand. The more Federal Reserve Notes it digitally prints, the less they ultimately will be worth. We know how this game will end. We just don’t know when.