It's September 2013 and the United States is contemplating military action against Syria. As fear is mounting, investors shrug off the dangers ahead. It's only with the benefit of history that we will know how events unfolded: how stocks, bonds and the U.S. dollar fared.
Before we dive into this analysis, be forewarned that we are writing from the fictitious viewpoint of 2020. We have no way of knowing whether what we write will happen. We did not come back from the future and events might unfold differently. Proceed at your own risk.
As the United States was getting ready for military action in September 2013, the warning signs were abundant:
• Treasurys, the traditional "safe haven" in times of crisis, appeared anything but safe. Yields on the 10-year note moved up to 3 percent. It was in July 2012 that Treasurys yielded less than 1.4 percent. That was then. But ever since May 2013 (when the 10-year yielded 1.6 percent), interest rates have been rising, that is, bond prices have been falling. Safety in Treasurys? Not quite.
• Stocks, in contrast, were on a tear, up over 20 percent in just a year. Indeed, investors appeared to have been conditioned to buy on every dip. It was fascinating to see how pundits told investors to "buy, buy, buy," ignoring the most apparent of all bubble indicators.
• And the greenback! It was so engrained into investors' mind that the dollar must go up in times of crisis that few noticed that what was then called the cleanest of the dirty shirts by someone crowned to be a bond king wasn't clean after all. Few noticed that the euro was the best performing major currency year-to-date. The greenback actually fell as the Syria crisis mounted. Was the inability of the dollar to attract demand in times of turmoil a sign of things to come?
Bubble Indicator Flashing
The bubble indicator referred to above cautioned about tech stocks in the late 1990s and suggested easing on stocks in 2013. The indicator measures complacency: when everyone thinks they know where the market is going, implied volatility in that asset class goes down.
The dogma of "stocks for the long run" becomes re-established and a rising equity market becomes self-reinforcing. The more stocks rise, the more popular they become and the more risk becomes mispriced.
Looking at a long-term chart of the CBOE Volatility Index (VIX), a popular measure of implied volatility in the U.S. equity market, equities look to be very close to the low end of their range at a time when stocks are near all time highs.
Caution: the sections "October 2013 Flash," "Great Recovery" and "Dollar Crash?" are entirely fictitious. While it may be possible for events to unfold as discussed, we have no way of knowing. The discussion serves as an illustration of the sort of risk scenarios that might unfold, but is not to be construed as investment advice.
October 2013 Flash
Stock investors in October 2013 felt like gold investors earlier that year. Someone decided to take profits from what appeared to have been an endless rally. And this time around, others did not pile in to "buy the dip." In fact, high-frequency trading algorithms noticed the unusual pattern in the market and opted to pull their bids.
It first appeared like a flash crash as prices plunged. But past flash crashes had the habit of rebounding within seconds — this one was different. It was painful. The bids didn't come for what seemed to be an eternity. Margin calls followed, further extending the pain. It became known as the October 2013 Flash, or simply the "Flash."
The doomsday predictors didn't like it, but we recovered from the Flash. It took a while, but the pundits got what they were asking for: economic growth. Except that it didn't play out the way the cheerleaders wanted it to.
As the economy picked up steam, bonds continued to slide. We were told that it was good news as the economy was healing. We will spare you the details, but someone finally looked up the numbers: in 2001, the average cost of borrowing for the U.S. government to borrow money in the market was over 6 percent. In August 2013, that average cost dipped below 2 percent.
It didn't happen overnight, but it's now 2020. We won't spoil the surprise for you, but the market started to have concerns that meaningful entitlement reform wouldn't happen. It's 2020, and it didn't. Now interest rates are not only high, but the average cost on all debt servicing has moved up.
How much? Kids may be reading this, so we can't put these numbers in print. The details, in fact, don't really matter, as it is the perception that counts. Once confidence was lost that the United States could service its debt in real terms, the market didn't care about the rhetoric of policymakers that the United States wouldn't ever default because it can print its own currency.
And as the Federal Reserve was called upon to help finance government deficits, we could tell you what unfolded. We could tell you whether the dollar crashed. But we don't want to spill the beans for our readers. Let us just ask: what's your assessment of the risk of this scenario unfolding?
By the way, the 2020 Olympics took place all right, but the International Monetary Fund (IMF) had to step in as Japan was unable to finance the completion of construction. Athletes had to pledge their sponsorship deals as collateral as the IMF would have otherwise been unable to access funding.
Back to Reality
Okay, we got ahead of ourselves. It's utterly unrealistic for the IMF to step in to finance the 2020 Olympics. To distinguish fiction from reality, let's not veer that far into the future, but look at what is next for the dollar in the context of the Fed's taper talk.
The outcomes described herein are suppositions or fictitious and there can be NO ASSURANCE that the trends described will come to pass at any time, present or future.
We manage the Merk Hard Currency Fund, the Merk Asian Currency Fund, the Merk Absolute Return Currency Fund, as well as the Merk Currency Enhanced U.S. Equity Fund.
Axel Merk, President & CIO of Merk Investments, LLC, is an expert on hard money, macro trends and international investing. He is considered an authority on currencies.
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