Alternatives: Coming Out – As A Bear! by Axel Merk, Merk Investments

Increasingly concerned about the markets, I’ve taken more aggressive action than in 2007, the last time I soured on the equity markets. Let me explain why and what I’m doing to try to profit from what may lie ahead.

Alternatives: Coming Out - As A Bear!

I started to get concerned about the markets in 2014, when I heard of a couple of investment advisers that increased their allocation to the stock market because they were losing clients for not keeping up with the averages.

Earlier this year, as the market kept marching upward, I decided that buying put options on equities wouldn’t give me the kind of protection I was looking for. So I liquidated most of my equity holdings. We also shut down our equity strategy for the firm.

Of late, I’ve taken it a step further, starting to build an outright short position on the market. In the long-run, this may be losing proposition, but right now, I am rather concerned about traditional asset allocation.

Fallacy of traditional asset allocation

The media has touted quotes of me saying things like, “Investors may want to allocate at least 20% of their portfolio to alternatives [to have a meaningful impact on their portfolio].”  The context of this quote is that because many (certainly not all!) alternative investments have a lower volatility than equities, they won’t make much of a dent on investors’ portfolios unless they represent a substantial portion of one’s investment. Sure, I said that. And I believe in what I said. Yet, I’m also embarrassed by it. I’m embarrassed because while this is a perfectly fine statement in a normal market, it may be hogwash when a crash is looming. If you have a theoretical traditional “60/40” portfolio (60% stocks, 40% bonds), and we suppose stocks plunge 20% while bonds rise 2%, you have a theoretical return of -11.2%. Now let’s suppose you add a 20% allocation of alternatives to the theoretical mix (48% stocks, 32% bonds, 20% alternatives) and let’s suppose alternatives rise by 5%: you reduce your losses to -7.96%. But what if you don’t really feel great about losing less than others; think the stock market will plunge by more than 20%; and that bonds won’t provide the refuge you are looking for? What about 100% alternatives? Part of the challenge is, of course, that alternatives provide no assurance of providing 5% return or any positive return when the market crashes; in fact, many alternative investments faired poorly in 2008, as low liquidity made it difficult for investors to execute some strategies.


Scholars and pundits alike say diversification pays off in the long-run, so why should one deviate from a traditional asset allocation. So why even suggest to deviate and look for alternatives? The reason is that modern portfolio theory, the theory traditional asset allocation is based on, relies on the fact that market prices reflect rational expectations. In the opinion of your humble observer, market prices have increasingly been reflecting the perceived next move of policy makers, most notably those of central bankers. And it’s one thing for central bankers to buy assets, in the process pushing prices higher; it’s an entirely different story for central bankers trying to extricate themselves from what they have created, which is what we believe they may be attempting. The common theme of central bank action around the world is that risk premia have been compressed, meaning risky assets don’t trade at much of a discount versus “risk-free” assets, notably:

  • Junk bonds and peripheral government bonds (bonds of Spain, Portugal, Italy, etc.) trade at a low discount versus US or German bonds; and
  • Stocks have been climbing relentlessly on the backdrop of low volatility.

When volatility is low and asset prices rise, buyers are attracted that don’t fully appreciate the underlying risks. Should volatility rise, these investors might flee their investments, saying they didn’t sign up for this. Differently said, central banks have fostered complacency, but fear may well be coming back. At least as importantly, these assets are still risky, but have not suddenly become safe. When investors realize this, they might react violently. This can be seen most easily when darlings on Wall Street miss earnings, but might also happen when central banks change course or any currently unforeseen event changes risk appetite in the market.

Relevant with regards to my concern over a more severe correction is that it is complacency that drove the tech bubble to ever new highs in the nineties; and it was similar complacency that drove housing into the stratosphere ahead of 2008. Bubbles are created when investors have the illusion that there’s no or little risk with the strategy they are pursuing, bidding up asset prices.

Did I mention that I’m concerned about stocks and bonds? That may not make sense to some, as bonds are the historic refuge when stocks tank, but just as stock and bond prices have both been rising, it is possible for both of them to fall simultaneously.

Why now?

Historically, it’s difficult to say when markets top, when bubbles burst. In my analysis, relevant is the rise of volatility, i.e. the return of fear. With hindsight, we will attribute that fear to a specific event, but to me, it’s secondary whether it is concerns about China, Greece, the Fed, Ebola, or what not. Remember that the market has been climbing a wall of worries? Well, similarly, the market can fall on good news or bad news. The question is what will get investors to think the glass is now half empty rather than half full.

As such, it’s difficult to get the timing right. It was in December 1996 that former Fed Chair Greenspan warned about irrational exuberance, yet the markets continued to rally until the spring of 2000.

I don’t claim to have a crystal ball, either. But I do know that if we have a severe correction, I prefer to be early than late: the time to prepare one’s portfolio for what may be ahead is before it happens. That’s why I explained I’m taking increasingly aggressive steps to protect myself, at this stage “starting to build” a short position. I can’t know for certain where my analysis will take me in the future, but should the market continue to climb, I don’t see that as a failure, but as a potential opportunity to increase my short position.

Part of the reason I’m willing to short the market is because, aside from the potential expansion of risk premia as the Fed is trying to engineer an exit, there are other red flags that suggest to me a more pronounced downturn may come sooner rather than later: