The market in the past few days has many investors worried. The world has grown accustomed to the steady climb that various major indexes have displayed in the past two years. In fact, in the past year, the market rarely saw any correction. This is considered rare even in any historical bull market.
However, for the past week (Monday 29th Jan 2018, to Today Friday, 2nd Feb. 2018), the market has steadily fallen. In fact, the Dow Jones has fallen close to 1,000 points. The last time the Dow fell over 1,000 points was in January 2016, when the Fed announced its initial plan to hike up the rates. The concern over higher rates had investors pulling away their money from the stock market. The Fed subsequently slowed its pace in rate hike. In light of the more Dovish approach, the market recovered quickly, and surpassed its previous highs, over and over again.
(DJX in the past week)
That brings to us today, the last trading day of a week in which the market declined nearly 4%. The important questions that we need to ask and that everyone is interested in are:
- Why are the markets falling this time?
- Are these reasons valid or are they irrational fear?
- How much will it fall or when is it a good time to buy?
- How do I invest in a bearish market?
Firstly, the market is falling largely because the renewed fear on interest rate hikes. This has caused the yield to pick up rapidly. A higher interest rate will cause companies to borrow at a more costly terms. Many companies today are plagued by overwhelming amounts of debt. Some of these companies have gotten used to the “pay-debt-with-more-debt” approach. However, if the interest rate rises in a significant fashion, these companies will have serious liquidity issues. A higher interest rate also benefits investors by offering them a higher alternative rate that is not in the stock market. Some may call it “risk free rate”. I, for one, do not buy into the “risk-free” concept. In any cases, facing a higher interest rate, investors will likely offer to pay a lower stock price (a.k.a. a higher return expected return).
In this sense, I believe that the reason is valid and is a cause for concern. Typically, a bull market ends because companies have accrued too much debt and the Fed has raised the interest rate. It is common today that a company has a debt-to-equity ratio over 200%, or even 300%. These numbers are not sustainable. They should be reserved for the most speculative and the most volatile companies in a healthy market. However, in today’s world, it is the norm. In 2015, the Fed has just started its plan to hike up rates. Unemployment was falling, but few believed it was the bottom. However, for the past 2 years, unemployment rate has fallen steadily and jobless report numbers have reached all-time-lows. The economy is in over-production mode. This is easy to see as commodity prices have gone up. Crude oil is trading at 65 USD per barrel, the highest in the past 38 months! Iron ore has rebounded from its previous abyss, currently trading at 75 USD per metric ton. Commodities typically are the last to go up in a bull market, because their prices are caused by accelerated inflation. Once the commodities’ prices have gone up, it usually means that the market has overreached and a recession is coming.
(5 Year Crude Chart)
In addition, there are some political unrest factors that are in play recently. However, I believe these are mostly non-material factors. Media today love to involve political factors, especially the U.S. politics, into the market analysis. However, as an investor, I simply find it hard to believe that any serious investor in the stock or bond market actually pays any attention to the trivial changes related to the White House.
With the understanding of why the market is falling, it brings us into the action-related questions: namely, should I invest or should I wait?
For me, the question, however, is never about should one invest. I believe you should always invest. The question is more “what should one invest”?
In a market that is like the one we have today, one is better off with a very conservative strategy. Low debt utilities stocks should take priority. Consumer staples should also relatively outperform other sectors in a falling market. Examples of consumer staples include eggs, tooth brush, toilet paper, and so on. The usage of these goods is not affected by unemployment. However, I advise you to be EXTREME CAREFUL when making investment decisions, because many companies that are in various industries, in the pursuit of a higher ROE, have deviated from the main branch of their businesses. They have taken on debt to invest in risky businesses on the side to generate a higher return for their stock holders. Therefore, even though they still have the name the description as a consumer staples company, investors must be extremely cautious and should look at closely what the management has been up to.
Furthermore, one could invest in non-US stocks. I have been personally bullish on Canadian banks for a while. Canadian banks are well-run and exhibit low risks. Most pay a healthy dividend around 3.5% to 4%. In a falling market, many investors will pay premium for stability and certainty. Canadian banks are likely to be the leaders in such qualities and traits.