By Kris Sayce
This week is set to be the biggest week for markets since… erm… last week!
It’s a week where the markets are again set to be duped by meddling central bankers… where investors once more are faced with no other choice than to second-guess the mad-cap plans of a man with a beard.
It could mean stocks stage a double-digit rally… a double-digit drop… or they could do nothing. If that sounds like financial advisory fence-sitting, you’re right.
As we’ve said many times, almost no-one is investing on fundamentals. Every investment decision anyone makes today has the same common denominator – Dr. Ben S. Bernanke.
But before we go through a simple example of how you can beat Bernanke at his own game this week, a recap of recent history…
On 26 August this year, U.S. Federal Reserve chairman, Dr. Ben S. Bernanke told a meeting of central bankers gathered at Jackson Hole, Wyoming:
“We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion.”
Over the following three days, the benchmark S&P 500 rallied 8.3%.
Today the index is up 7.1% since the Jackson Hole speech.
Compare that to the 14% rally from the 2010 Jackson Hole speech until the week before the U.S. Fed announced its USD$600 billion money-printing programme in November 2010.
As the Fed bought U.S. government debt, stocks kept going up… adding another 13.9% through to February this year.
But the main purpose behind the second round of money-printing – keeping interest rates low – was a total failure.
Rates actually fell before the Fed printed more money. But pretty much as soon as the printing was announced, the clever banks that had front-run the Fed started selling out… pushing interest rates back up.
Interest rates stayed high through that money-printing programme until talk started about another money-printing scheme (QE3).
As before, interest rates have slumped. But this time, to record lows. Even lower than late 2008 when the global economy was on the edge of collapse. Today, the U.S. 10-year bond yields just 2.08%.
Slightly better than the 1.90% yield it reached last week.
Part of the reason is many traders say the Fed will devise a modern version of a failed policy from the 1960s – Operation Twist.
This is where the Fed tries to skew the yield curve by holding short-term rates steady and pushing down longer term yields. In other words, encouraging businesses to borrow long-term. And also cutting the interest expense for the U.S. government… allowing it to borrow more!
To do this, the Fed would buy longer bonds… such as the 10-year bond. But, eager to get in first, banks, hedge funds and traders have again front-run the Fed. Hence why the 10-year yield has fallen from 3% to 2% in the past few weeks.
But our bet is the Fed will do much more than that. The market expects a new Operation Twist. And so the Fed will want to do this, plus more… anything to engineer a stock market rally.
The problem with central bank manipulation is it’s impossible to plan for the future with any degree of certainty. Because you have to think about what Bernanke will do this week, AND the impact it will have next week and the week after.
Add in the fact that even though we know Bernanke’s plan won’t work… there’s still a chance the broader market will think it’ll work. So what do you do?
Do you sell stocks knowing it’s all going pear-shaped? Or do you join in the madness and buy on the prospect of another money-printing rally?
Our long-held view is you should have no more than 20% of your wealth exposed to the stock market. If you’re a conservative investor then make that a maximum of 5-10% of your wealth.
We know that sounds crazy. And we know it’s against the advice of most mainstream advisors.
But the fact is, as a fundamental investor (that means we look at balance sheets, income statements and the nuts-and-bolts of a company) it’s hard to ignore one thing. That is, however good a blue-chip stock is, the only reason the price will rise or fall is based on what happens at the Federal Reserve’s next meeting.
That’s why we’re keeping our stock exposure to a minimum – we have two high-risk growth stocks and one lower-risk income stock on the Australian Small-Cap Investigator buy list.
But aside from using small-caps as a leveraged way to play the market, another way is to use contracts for difference (CFDs). Put simply, CFDs allow you to place a leveraged bet on a stock using a small amount of cash.
For instance, you could use just $100 to take a $1,000 position on a stock.
That kind of leverage isn’t for everyone. But if you take advantage of the guaranteed stop loss (GSL) facilities offered by some CFD providers, it’s a great way to take a punt on the direction of a volatile market. And at the same time you’ll know your maximum downside in advance.
We don’t recommend the use of GSLs all the time, because it can be expensive – you have to pay a charge to the provider to place a GSL. But it’s a good way to make a bet on a big directional market move.
This means that rather than having a bunch of cash spread across a number of different stocks, you can keep your cash in the bank and use a small amount to place a leveraged bet on just one or two stocks.
As we say, CFDs are risky and you can lose far more than you invest. If you don’t know anything about them today, we wouldn’t suggest plunging in to use them for this week’s expected market move. But if you’ve used CFDs before, but you’ve been scared off by the volatility, checking out guaranteed stop loss orders as a way to limit your risk from trading this market could make a lot of sense.
Cheers.
Kris
