U.S. Markets close in 1 hr 13 mins

Merk: Get Ready for a Crash

Yahoo! Finance
The Exchange

By Axel Merk

What’s the likelihood of a stock market crash? If you are reading this, odds are that, at the very least, you think a crash is possible. Well, are you prepared?

To understand how a stock market crash might play out, let’s look at the recent plunge in the price of gold, as the price action in gold and the S&P have a lot more in common than one might think. With at least one major difference: many buying the S&P are holding their nose, only jumping on the bandwagon to keep up with the index. In contrast, many that liked the shiny metal before the correction continue to like it.

Liquidity at risk

Clearly, the S&P and gold are not one and the same. But what happened to the price of gold earlier this year should be a warning to all of us: liquidity can evaporate in a heartbeat. In 1987, portfolio insurance was all the rage; investors thought they were “protected.” The October 1987 Crash proved that the insurance didn’t work. In today’s world of algorithmic trading, investors think they don’t need insurance anymore, as one can exit the markets in milliseconds. But as past “flash crashes” have shown, automated trading systems might just take a back seat if the market they trade falls outside of the range of expected market action. In other words: bids might be pulled, liquidity might disappear.

Investors in the current bull market have been taught to buy every single dip. In my assessment, clients often forgive their investment advisers for underperforming in a bear market, but can be merciless when advisers don’t keep up with the indices in a bull run. So is it possible that someone might want to take a profit one of these days? And what about if others start to take profits too in these markets that have the hallmarks of being driven by a crowd mentality?

The ultimate test of whether one is over-exposed to any one investment may be whether one loses sleep over it. I can sleep very well with my gold holdings. But after growing increasingly concerned about my personal stock market exposure, I put some hedges in place. This shouldn’t be construed as investment advice, but as an encouragement for investors to have a critical look at their asset allocation.

Rebalance in good times

We don’t have a crystal ball that tells us whether or when the markets will crash. But the time to rebalance one’s portfolio is when things are going well, not after a correction – or crash – takes place. The tough part, of course, is that the alternatives don’t look so great, either. Bonds may be at risk too. And even cash isn’t what it used to be, given that the purchasing power of the dollar with negative real interest rates. What else is there?

Axel Merk is President and CIO of Merk Investments, Manager of the Merk Funds. Follow him at: twitter.com/AxelMerk.