DataTrek: The 5 Scenarios That Could Crash The Market, And How To Hedge Them

Submitted by Nicholas Colas of DataTrek

Today, Nick Colas and his team at DataTrek Research play the contrarian and offer up 5 scenarios that could dent the stock market’s recent run along with a few cheap hedges to mitigate their effect on portfolios. While not calling for a top, Colas says that the current maxed-out bullishness "simply makes us nervous. Really, really, nervous." And while it may not be time to get defensive, "it is certainly time to consider what may cause a reversal. And how to plan for it now."

Colas explains:

It makes me nervous when everybody likes something. Tell me that I simply HAVE to see a movie or Netflix series, and chances are excellent I never will. It is probably the +30 years on Wall Street that have colored my worldview. Hear enough exaggerations from CEOs and finance professionals and after a while you acquire a very skeptical eye. And sleep with it wide open.

So the melt up for US equities since January 1st has me very conflicted. On the one hand, I get the enthusiasm – we’ve written almost daily about why tax reform will help the US economy and corporate earnings in 2018. We’ve talked about how numbers still have to go up. But as we edge ever higher, US stocks begin to feel like bitcoin in the run up to the start of futures trading late last year. Everything is great, but everyone knows everything is great.

We’re not pulling the plug here, but it is time to consider what assets to add to a portfolio as a hedge. The troublesome question is: “Hedge against what?” We are never going to be on Team Fed-haters, or Team Valuations-Are-Insane, or Team Impeachment for that matter. But US equity prices are priced to perfection, and the world is an imperfect place.

Today we’ve pulled together a list of some bearish equity scenarios we hear frequently, and offer up a few notional hedges against each.

Scenario #1: Trade War

Between President Trump’s upcoming speech at Davos and the State of the Union address on the 30th, trade is going to be an important narrative in markets over the next 2 weeks. I encourage you to read the link about Robert Lighthizer, US Trade Representative. His views on trade closely mirror the President’s, but may actually be more strident. Even very knowledgeable Washington insiders we speak to say the Administration’s approach to trade is unpredictable at best.

If capital markets start to worry on this topic, we suspect equities will decline but bonds will rally in a classic “Risk off” trading pattern. Yes, protectionism is theoretically inflationary, but it is also a headwind to economic growth and therefore recessionary and that should push yields lower. The dollar should weaken further as well.

Recommendation: Buy long dated Treasuries (but not corporate bonds, especially those of large multinationals) and gold (but not silver, which is as much industrial commodity as precious metal). Small caps, with less overseas exposure than large caps, should outperform large caps.

Scenario #2: Unexpected Large Scale Military Action Outside the Middle East

While we place a low probability on this outcome, a recent poll of Davos WEF participants put it near the top of their list of worries (although not excluding the Middle East).

From a capital markets perspective, such an event would be a genuine shock since they have glided by escalating tensions on the Korean peninsula (the hottest “Hot Spot” on the planet at the moment). And the upcoming Olympic Games there have clearly helped diffuse tensions, just as they did in ancient Greece when all cities laid down their arms to compete. Still, the world has plenty of troublesome zones, and not all of them are competing in PyeongChang.

Same recommendation as a Trade War: long dated Treasuries and gold. Defense stocks should do well, but airlines will likely suffer.

Scenario #3: Generic 5-10% Pullback in US Stocks

This is the one we worry about daily, because we simply don’t know the narrative that will cause it. If we had to guess, it will be something market-specific (rather than macro) such as a large hedge fund in a sudden liquidity crunch. Correlations have broken apart in recent months, after all, so the models many funds use may have led them astray.

Recommendation: The risk of this scenario is one reason to lighten up on equities right now and raise cash, because there is no obvious hedge. Treasuries may not rally much in a market dislocation driven by a Long Term Capital-type sell off. Sector, market cap and geographic correlations will quickly cluster at 1.0. Short of increasing a cash allocation, the only alternative is to sit and ride out any volatility or buy some cheap put options if your investment mandate allows it.

Scenario #4: Inflation Scare/Suddenly Higher Rates

This one feels like the most likely of our sell-off scenarios, if only because market psychology is primed to accept the narrative. We recently heard a bearish call on US large cap Technology predicated on what higher rates will do to stocks with lofty PEs, for example. News of companies paying cash bonuses and giving raises feeds this storyline as well, and investors could easily embrace an “Inflation now” mentality long before the data supports it.

Recommendation: Commodities and equities in the Materials/Energy/Industrials Space. We’re already seeing a piece of the trade go on – investors have placed an incremental $830 million in the two largest gold ETFs since the start of the year. Energy stock ETFs have pulled in more capital ($1.9 billion) than those dedicated to the Tech sector ($1.6 billion). And Industrial sector ETF money flows have them both beat, with $5.1 billion of inflows.

Scenario #5: Oil/Generic Economic Shock

Long time market watchers know that the burial ground of bull markets is located in the Middle East. A spike in geopolitical tensions there flows quickly to oil markets and then to the gas pump and stock prices.

Recommendation: Energy commodities and stocks, for the obvious reasons. Treasuries and gold as well, for their safe haven status.