Investing for Worst Case Scenario

Chidem Kurdas

German national output declined in the fourth quarter.  If the recession caused by the European debt crisis spreads and engulfs the world economy, a crisis situation like 2008-2009 could again develop, with all markets going downhill together. What type of investment will perform in this worst-case scenario?  

According to a report based on the views of BlackRock portfolio managers, alternatives offer protection for long-term investors if the underlying investment can withstand a deep recession, short-term funding crunch or regulatory crackdown.

For hedge funds, this means managers that can survive mass redemptions, a sudden cut-off in credit and regulators’ bans on short-selling—all the adverse events that occurred in 2008-2009.  That could be funds in liquid strategies that do not rely on credit.

A second condition necessary  for successful crisis investing is to have long-term staying power; not to have to sell when prices plunge and ratings drop. In addition the BlackRock report emphasizes “how important it is to pick the right manager in alternative investing.” Indeed, the performance dispersion among managers is wider than ever, so that investors in the same strategy can make money or lose money depending on the manager they’ve chosen.

Not that BlackRock presents global recession – the report calls it Nemesis after the Greek goddess who punishes hubris – as likely. Chief equity strategist Bob Doll says the US economy will likely muddle through 2012, with growth constrained by continuing de-levering but still positive.

However, the advice is to hold some cash in case Nemesis happens, whether because of the European situation or other possible triggers. The BlackRock report mentions for instance a growth shock in China due to bad policy moves or an Israeli strike on Iran’s nuclear facilities that causes oil prices to hit $150 a barrel.

Cash gives you protection in a liquidity crisis but also the wherewithal to take advantage of buying opportunities. As BlackRock points out, stocks, junk bonds and natural resources were great buys in early 2009. The hedge funds and investors that were able to buy then and hold on did well.

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