I am firmly convinced that every investor should have a financial exit strategy. I define this as any way your investments can reasonably pay-off, even if the markets remain stubbornly against you.
For example, a dividend investor doesn’t count on having to sell his securities for more than their purchase price, although such an outcome would certainly be welcome. Instead, his implicit financial exit strategy is simply holding his stocks until the dividends have grown large enough to constitute a substantial portion of their original cost. This is also called yield-on-cost – a sacred concept for many dividend investors.
Another example of a financial exit strategy would be applicable to growth investors. These investors buy rapidly growing (but often cashflow negative) small or medium-sized companies in the hopes that the market will recognize and reward this success with an elevated share price. But if the market, for whatever reason, chooses to low-ball a growth investor, he can continue to hold the company until it eventually becomes large and successful. At that point, the firm will almost always pay out a generous dividend. This eventual dividend cashflow is the financial exit strategy for growth investors.
Microsoft and Apple are classic examples of this approach in real life. They both began as small, rapidly growing companies that paid no dividends (and required lots of financing) and ended up as massively successful companies that paid large dividends. If, as a growth investor, you felt that they were not being awarded the proper growth multiple, you could simply continue to hold, waiting for your financial exit strategy to work.
But a theoretical financial exit strategy isn’t always foolproof. It is possible that a dividend investor’s chosen stock fails to grow its dividend, in which case the default method of cost-on-yield escape is non-operative. Likewise, a growth investor may find that his rapidly expanding company runs out of liquidity or faces a shrinking customer base due to a recession. In these instances, that small, formerly fast growing company will never mature into the large, dominant firm originally forecast.
And this brings us to our pertinent question for the day: What is your financial exit strategy? Unfortunately, I think for many investors the answer is “I don’t have one!”
The raging bull market of the past 9 years has made many market participants complacent. They either believe they don’t need a financial exit strategy or that relying on central banks’ endless quantitative easing (QE) is sufficient. But I think this is a poor substitute for actual risk control.
And this line of reasoning inevitably brings us back to my favorite asset class – hard assets like fine art, antiques and precious metals. Even a modest allocation to these overlooked tangible assets can help diversify a traditional stock and bond portfolio in a way that other paper assets cannot. And this realization has extremely important future implications for your financial health.
Under normal circumstances, a portfolio composed solely of stocks, bonds and cash is safe enough. But we are not living in normal times. Instead, we are drifting through the hazy twilight of our current debt-laden, dollar-based age, which is sometimes known as Bretton Woods II.
I recently stumbled across a whitepaper from a financial firm called Myrmikan Capital, LLC that illustrates my worries about our current financial predicament quite succinctly. I have excerpted the pertinent portion below:
In 1940, for example, when the roaring ’20s had been fully liquidated, the Fed’s gold backed its liabilities by 88%. There was very little credit in the dollar system, which made it a good time to own stocks. By the top of the 1960s bubble, the Fed had monetized so many government bonds that, at the pegged and London market price of $35 per ounce, gold backed the Fed’s liabilities by just 12%. That was a great time to own gold (had it been legal for Americans to do so).
On January 21, 1980, the spot price of gold hit a peak of $875, which meant that the gold on the Fed’s balance sheet backed its liabilities by 133% – in order words, its liabilities were overbacked by 33%. That was not a good time to own gold. Today, the Fed reports it holds 8,133 tonnes of gold, worth $349.4 billion at $1,330 per ounce, which equals 7.9% of the Fed’s reported $4.4 trillion in liabilities. Now is a good time to own gold. Better than in 1968, in fact.
Prior to reading this, I had written an article on the stair-step pattern clearly visible in the long-term price of gold, which perfectly mirrors Myrmikan Capital’s analysis. This is frightening stuff, or it should be for any conventional stock or bond investor. Simply put, the Federal Reserve and other global central banks are engaged in naked inflationism. And while the ultimately negative consequences of their profligate monetary policy have not yet arrived for the most part, stand assured that they are coming.
I have an analogy to describe the current financial system. Suppose you are attending a wild rave on the top floor of a ramshackle apartment complex. The guests are, without exception, all either drunk or high. The booze and drugs are flowing freely. And suddenly someone opens up a closet and discovers boxes filled with fireworks and oil-soaked rags. The party guests are enamored with this find and waste no time breaking out their lighters.
You and I both know what is going to happen. That is why, in this analogy, I am slowly edging towards the apartment’s fire escape. I want to be the first one out when the inevitable disaster strikes, because very, very few people will manage to escape. Tangible assets – precious metals, antiques and fine art – are a way to emerge financially intact from such as catastrophe. They give you a viable financial exit strategy from a market that loves playing with fire.
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