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Dysfunction in Washington is amplifying market volatility and exposing investors to unacceptable risks. Those who adhere to traditional 60/40 portfolios are foregoing the necessary protection from a recession and the bear market that will follow.
As the United States and China ratchet up their trade war, volatility is hitting financial markets. Earlier last month we saw a several-hundred-point drop in the Dow Jones Industrial Average. Yields rose sharply on the 10-Year Treasury note – then dropped to 2.15%, its lowest level since September 2017. While nobody knows whether this turmoil marks the end of our 10-year-old bull run in stocks, one thing is clear: Investors are recognizing there is an inevitable bear market on the horizon.
The wipeout of recent gains is a sobering sign of how the markets are becoming increasingly dependent on investor sentiment dictated by Washington, D.C. Regardless of your political affiliation, this dependency should be extremely concerning as we move closer towards the next recession.
Since the 1980s, both Democrats and Republicans have misused their political power to increase federal spending to unsustainable levels effectively fueling massive debt and artificially juicing economic activity. This increase in expenditures has coincided with greater government intervention in the capital markets and private sector. Naturally, investors have gotten comfortable with what amounts to manufactured backstops that have come to life through artificially low interest rates, stimulus packages and quantitative easing.
The problem for the average investor is that there is a shot clock on the government’s ability to prop up markets. Moreover, Congress and the executive branch are known to cause just as much harm as good when it comes to fiscal and trade issues. The next recession cannot be cured through a congressionally-authorized bailout or central bankers buying troubled assets because the money simply is not there.
With more than $20 trillion in federal debt on the books and no plan for repayment, the next bear market may be the most prolonged and painful one in a generation.
A natural question for investors now is how do I protect my portfolio during a devastating downturn? The long-held belief that market risk can be offset by simply diversifying across stocks and bonds is not the answer. In fact, that philosophy, known as Modern Portfolio Theory (MPT), never helped investors effectively limit the devastation unleashed by the dot.com bust, the recession of 2000-02 or in the global financial crisis. Industry professionals may tell investors these are hundred-year storms, but history shows that these painful market declines happen far more often than once a century.
