How Will You Protect Your Portfolio During a Crisis?

Jay Peroni, Lead Analyst, CEO and FounderBlog (Public), Crisis Investor

Cash Is King?

In Times of Deflation and Instability

During times of prosperity and rising financial markets, the directive to stay “fully invested” can be heard across the investment universe. But in times of instability and falling financial markets, it’s more important to be “in cash”. That’s the state of having a disproportionate amount of your money in a readily liquid form, to A) protect it from losing value, and B) to have it ready to take advantage of investments at bargain prices later in the down cycle.

What Is ‘Cash’?

Cash is the most liquid form of barter in an economy. In earlier times, it was comprised of precious metals, such as gold and silver, or of certain commodities, such as tobacco leaves or tulip bulbs – anything that a society considered to be extremely important.

Today we think of it as legal tender issued by governments. As such, it has a standard value, and can be exchanged for goods and services, as well as for payment of wages, debts, and taxes.

While we often think of cash as the Federal Reserve Notes we hold in our wallets, but it can also be held in the form of checking and savings accounts, customer payments, money market funds, and very short-term government securities.

The US Dollar as Cash

Here in the US, and in fact in virtually the entire world, the US Dollar is the primary form of cash. That’s because it is accepted as legal tender not only within the US, but throughout the world. The US dollar is the world’s international reserve currency, which means that international debts between countries are paid in dollars, even if the US is not involved in the transaction in any way.

Oil is a primary example. Around the world, oil is paid for with US dollars. The connection is so intimate that it is described with the word petrodollar.

In addition to its value as the international trading currency, the US dollar is the most widely held reserve currency in the world. The Wall Street Journal reported that nearly 63% of international reserves were held in US dollars at the end of 2014.

That makes the US dollar the closest currency on the planet to a truly international currency.

The Dollar Will Likely Rise in a Deflation

The dollar falls in value during times of inflation. That’s actually the definition of inflation – that the value of the currency falls, not that prices rise. And it’s widely believed that the US dollar could crash completely in a hyperinflation.

But in a deflation, the exact opposite is likely to occur. Deflation means that the value of goods and services fall against the currency. In that scenario, the dollar actually becomes more valuable.

This takes place because the number of dollars in circulation declines. There are simply fewer dollars chasing the same amount of goods and services.

We’ve already been experiencing deflation in certain economic sectors. Oil is a prominent example. Where it took more than $100 to purchase a barrel oil in the middle of 2014, it now takes barely $30.That’s an example of deflation.

Deflation can come about for a variety of reasons. Most commonly it happens because the nation’s central bank decides to reduce the supply of of the currency through various means.

But in more extreme examples, it comes about because of a sudden and dramatic decline in the amount of currency. This can take place as a result of a severe stock market crash, a debt collapse, or even a major natural catastrophe. The destruction of common asset class values has the effect of reducing the amount of currency in circulation.

Once that happens, there is simply less currency available to satisfy debts and other obligations. And since the US dollar is the international reserve currency, the effect of the deflation could be much more severe, as well as global in scope.

What Is a Fiat Currency?

Fiat currency is money that is declared to be legal tender by the government, even though its value is not backed by a physical commodity, such as gold or silver. The value of the currency is established in part by government decree, but more significantly by public confidence not only in the currency itself, but also in the government and the economy.

Virtually every currency issued by every government in the world is a fiat currency, since none are fully backed by a set amount of gold, silver, or anything tangible. That includes the US dollar, despite its status as the international reserve currency.

However, the fact that the dollar is a fiat currency is less significant in a deflationary environment than it is in an inflation. This is because major episodes of deflation are usually caused by a large-scale destruction of capital, in combination with the inability of governments to get replacement currency in the hands of its citizens without triggering a hyperinflation.

Though we often hear about Ben Bernanke’s “helicopter drop” of currency in the face of deflation, it’s just a theory that has not been successfully tested. In fact, anywhere in the world where it’s been tried, it’s led to a hyperinflation.

Moving From Risky Assets to Relative Safety

In the event of a serious deflation, or even an inflation or hyperinflation, it becomes mission-critical to move your capital out of the riskiest assets, and into assets that are relatively safe. In a deflation, cash is probably the safest of all asset classes. Once again, this is because cash isn’t subject to market declines, and it can even increase in value relative to goods and services.

But moving into cash can be problematic when you hold multiple investments.

In portfolios held in tax sheltered retirement programs, like IRAs and 401(k) plans, going to cash is usually easier because there are no tax consequences involved in selling equity investments. You can simply liquidate risky investments, and move the money into money market funds or stable value funds. You should also move old 401(k) plans over into IRAs, where you will have a wider selection of investment options, as well as more control over the account.

Money held in investments in taxable accounts are more complicated. If the sale of risky assets involves capital gains, you will be creating a tax liability when you sell them. But paying a capital gains tax of 15% to 20% may be preferable to watching 50% of your investment decline in a market collapse.

Once you sell investments in a taxable account, you should look to move the money into cash equivalents, such as very short-term U.S. Treasury bills, or in Treasury backed money market funds. This will enable you to preserve your capital during the worst of the deflation, so that you’ll have it available when conditions improve and markets begin to rise again.

ETFs That Rise When the Dollar Rises

You may actually be able to increase your investment returns with certain investments that will benefit from the rise in the dollar. And there are certain exchange traded funds (ETFs) that are set up to do exactly that.

One example of such an ETF is Power Shares DB US Dollar Index Bullish Fund (Symbol: UUP). The Fund is designed to replicate being long on the US Dollar against other major international currencies, including the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. That means that it is designed to be a play on the strength of the US dollar versus other currencies.

While it may be true that other currencies attempt to match the swings in the US dollar, a major deflation would likely cause imbalances in the international currency markets. This is because in a global crisis, both investors and governments would likely seek out the safe haven status of the dollar, rather than all of their local currencies. This means that it’s not only possible for the dollar to rise in value against goods and services, but also against international currencies.

Another way to play deflation is through the SPDR Barclays 1-3 Month T-Bill Fund (NYSE: BIL). This is a fund that attempts to match the results of the price and yield performance of the Barclays 1-3 Month U.S. Treasury Bill Index, before fees and expenses. It’s a way of moving your money into short-term US Treasury Bills, without being limited to just one or two issues.

Using Inverse Currency ETFs to Play Currencies that Fall Against the Dollar

Inverse currency ETFs are another way to benefit from currency deflation.

ProShares UltraShort Yen (Symbol: YCS) is an example. The fund seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the US dollar price of the Japanese Yen, before fees and expenses.

ProShares UltraShort Euro (Symbol: EUO) is an another example of an inverse currency ETF, but it’s centered on the Euro. The fund seeks daily investment results that correspond to two times the inverse (-2x) of the daily performance of the US dollar price of the Euro, before fees fees and expenses.

Either fund will enable you to turn a profit on US dollar strength against either the yen or the euro.

If you suspect that a major deflation is coming – and all the signs seem to be there – then you should make an effort to protect your investments from the fallout. These are just some examples of what you can do to make that happen.

Additional Reading:

Fixed Income Challenges & Opportunities

Will Gold Protect You During an Economic Crisis?

Want to Make a Fortune? Buy Stocks at Depressed Prices!

How to Hedge Your Portfolio

Using Swing Trading to Profit in Volatile Markets

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While Dual Returns has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.