At the end of the trading day on August 22, 2018, the US stock market reached a historic milestone as the longest bull market in history, with a duration of nearly 10 years.
And while there was a brief but intense across-the-board correction in the fourth quarter of 2018, that bull market remains intact…for now. But it won’t last forever.
And while it’s easy to overlook them, the signs of an impending slowdown are everywhere. Simply put, it’s time to get defensive.
The 900-pound gorilla in the room is the world’s largest engine of economic growth: China. The Chinese economy is slowing down – fast. Officially, growth in China slowed to an annual rate of 6.4% in the last quarter of 2018. While that’s an enviable growth rate for most economies, it’s well below the double-digit average that prevailed from the 1980s through the early 2000s.
And China’s economy might be in worse shape than official statistics, which are widely distrusted, indicate. The country’s stock market fell 28% in 2018, although it’s bounced back in the last two months. Apple, General Motors, Ford, Fiat-Chrysler, and Jaguar Land Rover have all reported sharp decreases in sales.
But China faces worse economic headwinds soon. The trade war with the US shows no sign of easing, although President Trump extended the March 1 deadline to increase tariffs on Chinese goods imported to the US. But even the relatively small tariffs now in effect have slowed industrial production in China.
The Chinese economic model, predicated on rapid industrialization, is also running out of steam. For decades, China’s economy grew on the backs of laborers moving to its cities and working at assembly-line jobs. But labor costs have risen sharply, and China now faces competition from countries like Vietnam, where wages are significantly lower.
The only way China can continue to grow its economy is by developing high technology on its own. China has tried to accomplish that goal primarily by stealing technology from other countries. Many countries now are fighting back against that strategy, most recently by excluding Chinese phone giant Huawei from the impending rollout of 5G phone networks.
China also has a debt problem. To combat the effects of the 2007-2008 financial crisis, Chinese banks expanded their balance sheets by a stunning $15 trillion, to a total of $24 trillion. That’s 50% more than the assets of every global central bank combined. In January 2019, China injected an additional $685 billion into its financial system.
China now accounts for more than 60% of all the credit that’s been created globally in the last decade. No less an authority than the governor of China’s central bank, Zhou Xiaochuan, warned in 2017 that speculation and real estate bubbles in the country could lead to an economic catastrophe in China and throughout the world. Since then, the bubbles have only become bigger.
China isn’t the only economy that’s slowing down. Italy is officially in recession for the third time in a decade. In the UK, employment in services, manufacturing, and construction – the three primary drivers of the economy – are falling at the fastest pace since 2012.
Here in the US, the economy appears to be relatively healthy. But falling profits could spell an end to the bull market. More than 30 companies have already announced their first quarter 2019 earnings will be less than they had predicted. Back in September 2018, stock analysts predicted a 7% increase in S&P 500 earnings in the first quarter of 2019. Now they’re predicting a 1.4% decline.
So how can you protect yourself?
The cornerstone of any strategy to limit losses in a volatile market is the stop-loss order. A stop-loss order is instructions to sell an asset when it reaches a specific price in the market. The asset could be a stock, stock index, exchange-traded fund, commodity futures contract, etc.
A typical stop-loss strategy is to place 15% stop-losses on blue-chip stocks and 25% stop-losses on stocks whose prices are more volatile.
Stop-losses are less effective in markets with wild price swings. When falling share prices trigger a stop-loss, your position is sold at whatever the market price is when the order is executed. If prices are falling fast, that can be much lower than your stop-loss point. In many cases, prices recover almost as fast as they dropped. In the meantime, you’re stuck with a big loss.
To protect yourself from this whiplash effect, use stop-limit orders. A stop-limit order will sell only at your stop price or better. If the price of a share falls below your stop before the order executes, the shares won’t be sold. Stop limit-orders are effective in a “flash crash,” when the entire market loses value almost instantaneously then recovers nearly as quickly.
However, a stop-limit order won’t help you if your shares suddenly lose value due to a permanent loss of investor confidence. In that event, the share price is unlikely to recover. Investments in blue-chip stocks are one way to protect yourself. But even the most established companies sometimes experience sudden and massive losses in their stock price.
My larger concern, though, is that a bear market could turn into a systemic financial collapse. In that event, a loss in the value of your securities portfolio might be the least of your concerns. A more pressing issue could be that someone else has a superior claim to the assets you thought you owned.
I learned this lesson the hard way when MF Global, one of America's largest brokers in exchange-traded derivatives (options, futures, etc.), filed for bankruptcy in 2011. Total customer losses came to more than $1.6 billion, according to MF Global's bankruptcy trustee.
A tiny portion of that $1.6 billion represented losses in my personal MF Global account. When MF Global declared bankruptcy, the total value of my account was $19,452.22. Of that amount, $1,900 was in a highly leveraged futures position. The balance of the account, $17,552.22, was (I thought) in a segregated and firewalled account to which no creditor of MF Global had access.
I later learned that the $17,552.22 had been moved to MF Global's operating account. There, it had served as collateral for a speculative and highly leveraged investment by MF Global management. When the investment collapsed, MF Global's creditors collected the collateral in my supposedly segregated account.
Ironically, the high-risk leveraged futures position I held with MF Global remained intact. But it took me nearly two years to get back my cash.
Could this situation recur? Yes, it could. The rules that allowed MF Global to convert $1.6 billion of segregated customer funds into an ultra-leveraged investment remain in place. This scenario is most likely to unfold in a systemic financial crisis, when everyone is scrambling to raise cash.
Your right to the money in your bank account is even more tenuous. When you deposit money in a bank, you are turning your property over to that institution in return for a claim. The money is no longer your own; it belongs to the bank. Your legal status becomes that of an unsecured creditor holding an IOU.
This lesson came crashing down on depositors at Cyprus banks in 2013, when the European Union agreed to a multi-billion-dollar bailout of the Cyprus government. The bailout agreement was, in effect, a bail-in, as it forced uninsured depositors to pay some of the costs. The agreement wiped out deposits exceeding €100,000 at the worst capitalized bank (Laiki Bank). Uninsured deposits at the Bank of Cyprus took a 47.5% haircut.
In 2014, leaders of the G20, the world’s 20 largest economies, decided to impose rules that mandated bail-ins on bank depositors worldwide. The world’s megabanks now have official permission to pledge depositor accounts as collateral to make leveraged derivative bets. And if they lose a bet, the counterparty to the contract has first dibs on your money.
Economists call the risk of a collapse of an entire financial system systemic risk. The only way to defend yourself from systemic risk is to make sure your assets are held by the safest and most liquid brokers or banks and to use strategies that put you at the front of the creditor line if they do fail. And you’ll need to adopt strategies to protect your wealth from being grabbed by your own government.
I discussed these strategies recently in a three-part series of articles I shared with members of our Nestmann Inner Circle (NIC). To try a no-risk subscription the NIC and learn more ways to protect yourself from the next financial crisis, click here.
By minimizing the opportunities for creditors and governments to seize your assets, you’ll be in a much stronger position to protect your portfolio from systemic risk. And you’ll weather the inevitable financial apocalypse.