2016: The Year Leverage Bites

Savings, close up of male hand stacking golden coins over sky ba

Welcome to 2016, dear reader.

What will it bring?

Health, wealth and happiness…or losses, angst and anxiety?

I hope it’s the former, of course. But hope isn’t a strategy. And besides, we can’t divine the future. Things might go along nicely for you — financially and personally — for the first few months of the year. Then something could happen. The proverbial spanner in the works. What do you do then?

The point is: have a plan. Don’t go into 2016 with preconceived notions of what the market will do for you. You’ll probably be wrong.

At this time of year, market pundits come out with random guesses of what they think the market will do. Ignore them. They simply feed the human desire to want to know the unknowable.

Your best bet is to continue with the strategy or asset allocation that’s been working for you. Or if it hasn’t been working, change it. If you’re new to the world of investing, get a qualified person on board to help you get a start.

The other thing you need plenty of is patience. Not all asset classes perform well each year. Many people make the mistake of dumping what’s not working, only to look back in 12 months’ time and see that it started to perform soon after you got out.

But the world of modern financial markets is increasingly complex. Many asset markets move in tandem these days. That’s thanks to the huge influence central banks have on assets prices now.

They have been major market players ever since Lehman Brothers collapsed in 2008. That’s more than seven years of concerted central bank influence over the market. As a result, the major asset classes of bonds and stocks have done very well, thanks to low interest rates and quantitative easing.

Seven years is a long time, and there’s only so much juice you can squeeze from a lemon. 2015 might have represented the last few drops. As Bloomberg reports:

The idea behind asset allocation is simple: when one market struggles, it’s OK because an investor can jump into another that is thriving. Not so in 2015.

In fact, if you judge the past year by which U.S. investment class generated the largest return, a case can be made it was the worst for asset-allocating bulls in almost 80 years, according to data compiled by Bianco Research LLC and Bloomberg. With three days left in 2015, the Standard & Poor’s 500 Index gained 2.2 percent with dividends, cash is up less, while bonds and commodities show losses.

In the US — the heart of central bank intervention — stocks barely beat inflation, cash returned nothing while bonds and commodities went backwards. In other words, even a well-diversified portfolio lost money in 2015.

The article quotes Bianco saying:

The Fed stimulus lifted all boats, and then the Fed withdrawing the stimulus is holding the boats down… If the argument is right that the economy is going into 2016 weak and earnings are negative, those conditions will continue and therefore on the asset allocation level, I don’t expect anything to break out just yet.

The stock market doesn’t owe you anything. If you go in with too much complacency, it will pick your pocket. This central bank dominated, low return world could last for years. Or it could usher in increasing volatility…even more so than what you’ve experienced in recent years.

While you simply can’t guess what each year will bring, you can know the facts. And the fact is, the world is more leveraged now than it has ever been. As Ambrose Evans-Pritchard writes in the UK Telegraph:

Nobody knows where the pain threshold lies for a global system leveraged as never before. Public and private debt ratios are hovering at all-time records of 265pc of GDP in the OECD club and 185pc in emerging markets, 35 percentage points higher than at the top of the pre-Lehman credit bubble.

Leverage works both ways. If you think of a highly leveraged company operating when times are good, it will generate big returns. But when conditions change, the leverage will destroy it.

Think back to the days of Babcock and Brown. It was meant to rival Macquarie Group [ASX:MQG] and in the early years it looked like doing just that. But its success was built on leverage and taking on huge amounts of risk. When the credit bubble burst in 2008, it destroyed the company.

The global economy is in a similar position as we head into 2016. Increased debt across the globe has led to benign growth. As a result, the debt accumulation goes largely unnoticed. Because it’s not causing problems, it mustn’t be a problem.

But that’s not how debt works. It keeps growing until something goes wrong. And when it does, it goes horribly wrong.

Whether 2016 is the year that the post-2008 debt experiment goes horribly wrong is anyone’s guess. I don’t think you should sit in cash waiting for it to happen. But you should have a plan in case it does.

Towards the back end of 2015, I began preparing Crisis & Opportunity subscribers for such an outcome. I nominated a ‘credit crisis barometer’ stock to keep a close watch on. Stock prices move ahead of actual economic or financial events, so it should provide advance warning of any approaching storm. So far, it’s showing no signs of impending doom.

But that could all change quickly. Be prepared for anything this year.

Greg Canavan,

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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