The Next 'Minsky Moment' Is Inevitable... Prepare Now

It's time to talk about Hyman Minsky and his "moments"... while we still have the chance.

Minsky was an American economist who taught at American universities until his death in 1996. He's best known for his financial instability hypothesis – which, in short, says that financial crises are normal and to be expected.

As the Wall Street Journal reported in 2007...

Minsky... spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises. At a time when many economists were coming to believe in the efficiency of markets, Mr. Minsky was considered somewhat of a radical for his stress on their tendency toward excess and upheaval.

Nobody likes to hear it... but crises are an inevitable part of capitalism.

A "Minsky moment" is a crash that happens after an excessive debt buildup. The term was coined by investor Paul McCulley in 1998. Later, when the U.S. was on the brink of the 2008 financial crisis, he used it again...

As he told the Journal in August 2007, "We are in the midst of a Minsky moment, bordering on a Minsky meltdown."

Now, I've been talking about the probability of another crisis for a couple years. While I was right to be bearish in 2021 and throughout 2022, the S&P 500 Index is higher today than it was when the Federal Reserve started hiking interest rates last year.

So it looks for now as though the stock market has avoided a Minsky moment. Preparing for such an event seems to be the last thing on anybody's mind.

But I've probably said it a hundred times or more in my career: Prepare, don't predict...

Don't get me wrong. I often discuss what I believe will happen in the future – and I encourage you to do the same. Investors should do their best to "see around corners" and anticipate risks others might not see.

But when it's time to allocate your hard-earned capital, you need to be humble before the market gods. Admit that you can't predict what's coming.

Instead, you should position yourself for many possible outcomes. The best way to do that is to build a prepared portfolio...

Analyst James Montier of asset manager GMO recently published a white paper about three ways to prepare for crashes and crises. If you're looking for a way to arm your portfolio for a more difficult environment than the one we've seen since last fall, you must know these strategies.

First, hold cash.

Cash is the ultimate diversifier. The faster (and further) other assets fall... the better cash looks by comparison. Montier also points out that cash becomes more attractive as interest rates rise.

My wife showed me a bank statement last month and noticed the interest rate on our account was 5.96%. She said, "Hey we need to get some more money in there!" I did not disagree.

Investors can now get a decent return on the easiest way to protect their downside. If you want to be ready for tough market conditions, having plenty of cash on hand is hard (if not impossible) to beat.

Next, buy quality and avoid junk.

Montier's second strategy to prepare for tough times is to buy quality stocks and sell short "junk" stocks.

We don't short stocks very often in my Extreme Value newsletter. But we specialize in recommending high-quality stocks. We find companies using five essential traits of high-quality businesses: gushing free cash flow, consistent margins, good balance sheets, shareholder rewards (that is, dividends and share repurchases), and high returns on equity.

You can use the same five markers to identify junk stocks: negative cash flow, volatile or nonexistent margins, debt-ridden balance sheets, no shareholder rewards, and little or no returns on equity.

Professionals have used this strategy for many years. Every time I've spoken with hedge-fund manager Carlo Cannell over the past 20 years or so, for example, he has been short various junk stocks he expects to go to zero. He calls them "animals dying by the side of the road."

Finally, buy value stocks and sell short pricey growth stocks.

Montier explains that investors seeking to shield themselves from crashes and crises should "focus on assets with large margins of safety where the bad news has already been priced in." In other words...

Buying decent businesses with beaten-down share prices exposes you to less downside risk when the excrement finally hits the fan.

All these strategies make sense to me. I've shown readers how to use them all in one way or another over the years. And if you put them to work, they can help you protect your wealth from what Montier calls "slow burn Minsky moments"...

Montier doesn't quite say what he means by "slow burn." I have to assume he's saying the next crisis won't be as sudden as the 2008 financial meltdown or the dot-com bust... But it could be as traumatic.

So, protect yourself now – while a crisis is still the last thing on anyone else's mind.

Good investing,

Dan Ferris

Editor's note: The stock market has come roaring back... yet many investors are still shell shocked from the pain of 2022. If that's you, you're not alone. But what if you were able to tune out everything – from the fear of missing out, to the dread of a potential 2024 recession – with a strategy you could trust... no matter where the market heads next? That's exactly what Dan has set out to achieve. Check out his presentation right here.

Further Reading

"Why take more risk at an age when capital preservation should be your priority?" Dan writes. American retirees have been chasing bigger returns in the stock market. And the reason why could be dangerous to your wealth today... Read more here.

"You should have conviction in your investments," Sean Michael Cummings says. "But getting too sold on an investing idea can lead to bad decision making." This can happen easily when you fall in love with your own research. Here's how to avoid it... Learn more here.