Y2K Investing: Stock Up on Cash and Bonds -- or Canned Food and Bullets

Three possible scenarios and how to play them.
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All anybody really knows about Y2K is that, come Jan. 1, a lot of people are going to feel foolish.

The question is, who?

Will it be the grasshoppers who ignore the whole thing and wake up to find that the economy has shut down, and here they are with $8, a half-empty fridge and a cold house? Or will it be the ants who spend their last dime on gold coins, canned food and shotgun shells, thereby missing the next leg of the bull market?

Because the experts disagree on how bad it's going to be -- assuming it's bad at all -- Y2K has become a sort of cultural

Rorschach

test, telling us more about ourselves than about the problem.

At one end of the spectrum (surprise) are the religious fundamentalists who, anxious to get the sinning over with, seem to welcome an apocalypse. Huddled around the same fire are technophobes of the Unabomber variety who find poetic justice in the idea of technological society being snuffed by faulty technology.

At the other fringe are the people who like the modern world and can't believe the computer guys would be dumb enough to see this thing coming and still let it happen.

I'm in that latter group, or at least I was until I read a

Wired

magazine

article a while back about some big-time programmers who had been hired to fix the Y2K problems of some major companies. What they saw scared them so badly that they became survivalists, buying cabins and shotguns, taking courses in leather tanning and organic farming.

So maybe we should be doing something.

Speaking strictly from an investor's standpoint (this column, I promise, will never take a stand on bottled water or shotguns), there are three main Y2K scenarios, each of which is more or less exploitable. They are:

The Nonevent

The new year starts the way the old one ended: no change, no problem. If this is your prediction, then relax, kick back and let the growth stocks ride.

Or consider the following anxiety play: A lot of investors, just to be on the safe side, will buy bonds, raise cash and generally adopt a more conservative stance in December. When 1/1/00 dawns to business as usual, they'll spark an exaggerated "January effect" by pouring back into growth stocks.

So you might want to buy bonds now, in anticipation of the coming flight to quality. Then, as everyone else is buying bonds in December, sell them into strength and catch the falling growth stocks.

The Survivable Mess

Respected economist

Ed Yardeni

expects Y2K to cause a deflationary recession. That is, parts of the system (banks, brokers, utilities) will have problems, causing apprehension and a massive flight to quality. Consumer spending will temporarily plunge, causing the economy to shrink. The

Fed

will then flood the system with money, sending interest rates off a cliff.

The problems eventually get fixed, but a return to normalcy takes months.

Play this one right and you'll double your money in a year. Start by raising some cash and putting it in a safe place. Not a lot, just enough for a short credit-card-free period. With the rest of your free capital, buy long-term Treasuries. But this time, don't sell them in December. Just sit back as the mess unfolds, spend your cash, and watch your bonds appreciate.

At the first hint of stability, move out of bonds and into large-cap growth stocks, the likely first beneficiaries of an incipient recovery. Then, when the problems are clearly being fixed -- you'll see it here on

TSC

before the mass media catches on -- pile into small-cap growth and ride the next wave.

The End of the World as We Know It

You wake up on Jan. 1 and ... nothing. No heat, no TV, no phone. The only sound is snow gently falling and neighbors bartering eggs for toilet paper.

This is the scenario the

Wired

article sketched out, and it goes something like this: Power grids are run by millions of embedded microprocessor chips, each with their own Y2K problems. Most will be fixed, but not all. And the ones that fail will shut down certain grids.

Because the system is designed to route power around failed grids, it will do so, overloading other grids and causing them to fail. The result will be a cascade failure of the whole North American power system. To fix it, we'll have to fix the computers. But to do that we'll need electricity. A civilization-ending Catch-22.

This isn't likely (because, really, I have to repeat this, how stupid can these guys be to see this coming for decades and still let it happen?). But if it happens, then growth stocks are going to be about as valuable as a

Bill Clinton

promise.

Meanwhile, the traditional bear market tricks -- shorting stocks, buying puts -- will be doubly risky because they depend on functioning financial markets. So profiting might have to take a back seat to survival. That means liquidate stocks and go tangible for a while. You might also want to pay off your mortgage, not a bad investment in any event (because you earn a risk-free return equal to the aftertax cost of your mortgage) and generally settle outstanding financial issues, since debt is a problem when the economy doesn't let you earn much money.

Then think back to the most recent power outage, recall what you wish you had more of, and go get lots of it.

And wait. Worst case (or best case, really), you wake up Jan. 1 and everything's fine. You sell the gold coins at a loss, take out a home equity credit line and buy back all your growth stocks. You're down, but not out.

If everything's not fine, then you're a very smart person in a very nasty world. Not great, but better than the alternative.

John Rubino, a former equity and bond analyst, writes a column on mutual funds for POV and is a frequent contributor to Individual Investor, Your Money and Consumers Digest. His first book, Main Street, Not Wall Street, was published by William Morrow in 1998. At time of publication, he had no position in any stocks mentioned. While Rubino cannot provide investment advice or recommendations, he invites your feedback at

rubinoja@yahoo.com.