Why the Next Financial Crisis Will Be Nastier

Of all characteristics that made the 2007-2008 financial crisis unique, one stands out: The simultaneous decline of almost every asset category. US stocks dropped 37 percent, German stocks 42 percent, and Chinese stocks 62 percent; commodities dropped 37 percent (with oil and copper dropping 54 percent). This means that investors had nowhere to hide, taking multiple hits across their portfolios.

The roots of this broad decline in multiple asset categories can be traced back to the September 2001 Greenspan “put,” which lowered the cost of owning different assets. This means that investors didn’t have to sell one asset to buy another, as was the case before Greenspan’ put went in place. That explains why stocks, commodities, and Treasury bonds rallied simultaneously between 2001 and 2007—though T-bonds usually move in the opposite direction than stocks and commodities.

While helping all asset categories to rally, the Greenspan put had an undesired consequence: it caused a synchronous one-direction move across asset categories, undermining the effectiveness of asset diversification in lowering market risks. In other words, markets were in a “deadly embrace with each other,” as Financial Times columnist John Authers puts it in The Fearful Rise of Markets.

“It was March 2007 that I realized the world’s markets had each other in a tight and deadly embrace,” writes Authers. “A week earlier, global stock markets had suffered the ‘Shanghai Surprise,’ when a 9 percent fall on the Shanghai stock exchange led to a day of turmoil across the world. By that afternoon on Wall Street, the Dow Jones industrials Average suddenly dropped by 2 percent in a matter of seconds. A long era of unnatural calm for markets was over.”

That’s why the 2007-8 financial crisis was so severe.  Once one trade reversed course, so did other trades, creating a contagion that broadened and magnified the market correction.

That’s the good news.

The bad news is that, as the financial markets recovered, the positive correlation across asset categories has continued. In the last six months, for instance, iShares Barclays 20+ Year Treasury Bond (NYSE:TLT), SPDR Gold Shares (NYSE:GLD), and iShares Silver Trust (NYSE:SLV) moved higher by close to 10 percent. Obviously, the prospect of inflation caused by Quantitative Easing (QE) drove precious metals higher.

Why didn’t this prospect drive bond prices lower? Because of the Bernanke “put,” which now covers a broader category of assets, from Treasury bonds to mortgage back securities, to stocks.

This means that the next financial crisis will be even nastier. It will find many investors holding the same assets, all of which will correct simultaneously.

So what should prudent investors do? How can they protect their portfolios against this prospect?

Use financial derivatives rather than traditional asset diversification to cut markets risks.

Financial derivatives can work like traditional insurance: they shift market risks to somebody else for a fee (premium). Here are two trades to consider: First, buy in or out of money puts on SPDR S&P 500 (NYSE:SPY)or SPDR Select Sector Fund - Financials (NYSE:XLF), which has gained a great deal since the financial crisis. Second, buy volatility, through the purchase of iPath S&P 500 VIX Short Term Fund (NYSE:VXX) or indirectly through the purchase of Calls on VXX.

The bottom line: The resumption of easy money policy by the Federal Reserve in the aftermath of the 2008 financial crisis has re-affirmed and broadened the positive correlation of different asset categories, undermining the effectiveness of asset diversification strategy in reducing market risk. This means that, with investors trying to exit from several crowded trades at the same time, the next financial crisis will be much nastier.

Disclosure: Long on VXX and VXX calls; short on SLV

Also read:

The Good, the Bad, and the Ugly Side of Globalization

4 Red Flags for Global Markets