When the Dow Jones Industrial average fell 125 points on Thursday, it busted through the first great barrier separating Wall Street from the next crash.
Then, Friday’s 191-point plunge merely sealed the Dow’s fate, leaving the barrier far behind.
Now, brace yourself for the repercussions of today’s crash in Japan’s Nikkei 225 Index, down 432 points, or the equivalent of 380 points in the Dow.
You can see the Dow’s broken barrier in this chart, courtesy of BigCharts.com. It was right around the 10,400 level, where the Dow touched down in December, January, March and early April … each time bouncing back, meandering or holding.
You can also see the Dow’s free-fall toward 10,000. It has now plunged most of this year’s stock buyers into the red. And it’s now driving many to rush for the exits.
The picture in the Nasdaq is even more ominous: It never formed a clear barrier in the first place …
In early January, while the Dow was declining slowly, the Nasdaq was plunging sharply.
In March, while the Dow was holding firmly above its barrier, the Nasdaq was making new lows for the year.
And now, while the Dow’s free-fall is steep, the Nasdaq’s is even steeper.
What’s really happening? And why now?
For the past two years, since approximately the beginning of the Iraq War, Wall Street has been living a series of illusions —
that “the great bear market of the early 2000s was over” …
that the “run-away trade and budget deficits didn’t matter” and …
that “the president and Congress were in full control of our economic destiny.”
In reality, the bear market never ended. It merely paused. In fact, the Nasdaq, representing the core of America’s technology, didn’t come close to recovering its peak levels. It even fell far short of recouping just HALF its former high level.
In truth, the run-away trade deficit did matter. It drove the value of the dollar into a nearly non-stop tailspin … and it drove the United States deep into debt to foreign investors and central banks.
And in the real world, no branch of government can control the imbalances it creates — let alone their consequences. The most it can do is temporarily postpone the inevitable by pumping in more money … holding down interest rates … or offering more tax cuts.
The reason the market is falling right now is because all these illusions are fading, like the imaginary clothes on a naked emperor. Suddenly, a growing minority of investors are emerging from their slumber and beginning to confront the fact that:
America’s trade deficit is now the largest in history, over $61 billion in February alone.
The government ran a worse-than-expected $71.2 billion budget deficit in March. Just in the first six months of fiscal 2005, the cumulative deficit is $295 billion.
Foreign investors and central banks are fed up — sick and tired of financing our extravaganzas.
Fannie Mae and Freddie Mac, which helped drive the great American mortgage and real estate boom of the 2000s, are dead in the water, floundering, possibly sinking into an abyss.
The U.S. auto industry, which directly or indirectly employs 6.6 million Americans, is on the verge of chaos — gas-guzzling SUV’s speeding down the path of the Dodo or the DeSoto … General Motors speeding on a course that could lead to bankruptcy.
And …
Washington Has Run Out of Quick Remedies
The primary remedy was to shove interest rates down into the ground, to their lowest level in a half century. Now, the Fed has had no choice but to RAISE interest rates, and will almost definitely raise them AGAIN two weeks from now.
Another major remedy — tax cuts — merely helped create the largest budget deficit of all time, making it almost impossible to pursue the tax-cut path again for years to come.
Other remedies — like import quotas or simply “talking up” the markets — are also exhausted.
This brings you t
o a three-pronged fork in the road:
You can “stay the course.” Not recommended!
You can head for the hills. Not practical.
Or you can …
Buy Some Crash Protection
Suppose you want to hold on to at least some of your stocks.
Suppose you are unwilling or unable to sell your real estate.
Suppose you have a business or a job that could also be affected.
You see the dangers I’ve been warning you about. You want to do SOMETHING to protect yourself. But you’re not sure what.
One of the most straightforward approaches is to identify the single greatest threat to your assets … and then get yourself in a position to PROFIT every time that threat manifests itself.
Right now, I believe that threat is coming from RISING INTEREST RATES.
I see no other force that’s more pervasive, more powerful, or more inevitable. Just last week, it was announced that import prices skyrocketed 7.1% year-over-year in March, one of the worst inflation readings in years. This again underscores why the Fed must plow ahead with its interest rate hikes, whether the economy is deemed strong or weak.
To protect yourself, consider put options on stocks or bonds that are directly or indirectly tied to interest rates.
The basic idea: The more interest rates rise, the bigger the profits you can make. And the bigger your profits, the better able you will be to offset any damage that rising interest rates can cause to your real estate or stock portfolio.
So if you’re wondering why our interest rate options service is almost sold out, this is one key reason.
Another reason is the tremendous leverage these options offer, with your risk limited strictly to the money you invest and not a penny more. Just be sure to limit the funds you use to money you can afford to risk.
But you have other alternatives as well. For example, one solid — albeit less powerful — form of crash protection is through specialized mutual funds that are designed to go up as prices go down. For example …
Rydex Ursa Fund is designed to go up 1% in value for every 1% decline in the S&P 500 Index.
Rydex Arktos Fund is designed to go up 1% with every 1% decline in the Nasdaq 100 Index.
Rydex Juno Fund goes up 1% for every 1% decline in Treasury bond prices.
Plus, Profunds offers mutual funds that do essentially the same thing.
Consider these investments for your crash protection. If the markets go up, they will produce a loss, but your gains in your stock or bond portfolio should easily cover it. If the markets go down, you will at least have one investment working in your favor.
Here are some simple steps to follow …
Step 1. Evaluate all your holdings.
Do you own a lot of blue-chip stocks like GM or IBM? Or do you have mostly tech stocks? What about real estate?
To help protect a portfolio primarily in blue chips, I recommend Rydex Ursa or something equivalent.
To help hedge a portfolio primarily in tech stocks, I recommend Rydex Arktos or equivalent.
And if your portfolio is heavily loaded with long-term bonds or income-oriented stocks, consider Rydex Juno or something similar.
Step 2. Estimate your risk of loss.
No one knows for sure how far the stock market will decline. But based on past history, you can put together a few scenarios to evaluate your current exposure to risk. Consider these historical examples:
1. The average Nasdaq stock fell by over 60% in the 13 months from March 2000 to April 2001.
2. In Japan, the Nikkei Stock Index, which represents both blue chips and technology companies, fell by 71% from 1990 to 2001.
3. In the early 1970s, the Dow Jones Industrial average fell 43% from peak to trough.
These are all severe declines that hopefully will not be duplicated in your stocks. But they do give you some parameters. Without going over the deep end or conjuring up far-out doomsday situations, it is not unreasonable to assume a 40-60% decline in your stocks from current already-depressed levels.
To make it simple, take the current value of your portfolio, and give it a haircut of 50%. If your portfolio is worth about $100,000, your risk of loss, in this scenario, is $50,000. If you have $50,000, your risk is $25,000, and so on.
Step 3. Decide how much of that risk you want to protect yourself against.
If you wanted to protect yourself against the entire amount, you’d have to invest about dollar for dollar in one of the funds I just mentioned.
There’s nothing wrong with that. But most people prefer to buy only partial protection to cover, say, about half or even one-third of their portfolio. If your intent is to cover half, then, for every $1 of current value in your stock portfolio, you simply put 50 cents of your money into the appropriate fund. Assuming a stock portfolio worth $100,000, that’s about $50,000 you’d be allocating for crash insurance.
Step 4. Raise the funds for your crash protection.
Where do you get that extra $50,000? You could take it from your cash assets. But if you did, you’re in effect moving money from a safe investment (such as a money market fund) to a much more aggressive investment. That’s not very prudent.
My recommendation is to liquidate at least enough from your stock portfolio to finance your crash insurance. You don’t have to liquidate the full $50,000 worth of shares to raise the money. You’d only have to liquidate $33,333. The reason is that after you liquidate the shares, you will only need to protect the remaining $66,667 in your stock portfolio. The $33,333 is the exact amount you need to cover half your portfolio risk.
So the formula is simple: If you want to protect yourself against half your risk, you don’t want to use options and you don’t want to take money from another source, you should liquidate one-third of your portfolio to generate the money you need to buy crash protection. I think it’s cheap insurance.
Good luck and God bless!
Martin D. Weiss, Ph.D.
Editor, Safe Money Report
President, Weiss Research, Inc.
martinonmonday@weissinc.com
Martin Weiss and “Martin on Monday” are non-partisan. Third-party ads do not necessarily represent their opinion and should not be interpreted as an endorsement.
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