Remember Credit Quality?

Since November’s letter, Top of Tops, I’ve discussed the unfolding progress of the new bear markets in both stocks and bonds. While recognizing the risks of an impending bond market crash, we instead were treated to the beginning of a stock market crash.

On March 23^rd the Dow closed at 23,533, essentially even with the November 1^st close. But what a wild five months it has been for stocks. Almost straight up to the all-time high of 26,617 January 26th, to a 12% sell off in a mere ten days to a new closing low as of this writing.

I don’t just see possible horrific losses for stocks unfolding, I see probable horrific losses for stocks unfolding. This is why I have referenced the 1987 stock market crash (down 22% in one day, down 40% over eight weeks). The seemingly impossible has happened before. Who knows, this time it may be worse.

Conventional wisdom may direct investor’s funds towards bonds if such a stock market panic unfolds. That would be a mistake in my opinion. While stocks attempted to bounce since their 12% sell-off and have failed, bonds did rally. But this rally happened in the midst of a larger bond market sell-off.  With an overall downtrend for both stocks and bonds, if both do get aligned and move strongly lower together the resultant fear could heighten concerns of a crash in financial asset values.

It is best to forget the narratives. It is markets that are in control here, not this or that piece of news.  Certainly the wild activity of the past few months may have you baffled enough to realize the narratives given out for the markets fall and rise are just that: narratives.  Both stocks and bonds are in the early stages of reversing their thirty-plus year bull markets. This is the indispensable piece of information I have been working to impart upon you. Commodity prices (gold, silver, oil) have bounced of late, but their trend is also that of a bear. Together the scenario is called “nowhere to hide”.

Cash is the safe haven when all else is falling. However you can’t buy cash in scalable quantities. Instead you invest in short-term IOU’s like Treasury Bills, commercial paper, certificates of deposit or short-term municipal bonds or mutual funds that invest in these types of securities.

Short-term securities usually don’t fall much in price as interest rates rise (a continuation of the bond bear market) because they will mature soon. This short maturity feature also allows you to reinvest at the higher interest rates sooner, usually making short term securities a win-win in a bond bear market.

There is one caveat to win-win however and it is called credit risk. Credit risk (or default risk) is a term that is almost as out of vogue as the concept of investing in cash. With no defaults hardly to speak of, why would anyone care about defaults? It is also similar to thinking you don’t need to worry about a stock market correction (crash or otherwise) because one can’t remember the last one. Surprise, all of a sudden, credit risk is not only a thing – I believe in the months and years to come, credit risk will be THE THING.

Credit risk is THE THING because it is essential for your cash-type investments to maintain value. In a rising interest rate environment, short-term securities will mature shortly so you can reinvest at the higher rates quicker…provided the security is paid off at maturity.

In the municipal bond market place we have opportunities that do not exist in any other financial marketplace. There are tens upon tens of thousands of different credits which may become available each and every day. This is no different than last year, five years ago, ten years ago or thirty years ago. What is different is that I have been working with municipal bond credits for thirty years. We are entering this new phase of the financial markets with a plan, as well as the experience and expertise in what I believe to be one of the few opportunities available over the next few years.

Only you can control the mix of your investment assets. I believe there to be tremendous risk in the stock market right now and a stock market plunge will not be beneficial to bonds in my opinion. In my opinion, diversification is not a strategy for the future. Knowing your assets should be your strategy.