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Are we there yet? That is, have we reached a bottom; are we close to one?
If we only knew. Unfortunately, no one does. Things could improve, but they could get worse – a lot worse. We are seven years into a bull market, which is long by historical standards. Age alone, though, doesn’t turn a market. Potential instigators, on the other hand, do, and there is no shortage of those.
Earnings are one. FactSet reports that through the first quarter of 2016, 57 U.S. companies have issued negative EPS guidance compared to 14 companies that have issued positive guidance. Not surprisingly, many of the former companies are concentrated in energy. The entire U.S. shale exploration industry is threatened by low oil prices.
Across the pond, Deutsche Bank (NYSE: DB) and Credit Suisse (NYSE: CR) have investors on edge after reporting multi-billion-dollar losses.
On the Pacific side of the world, China’s economic slowdown has been well documented. Japan’s economy continues to languish, no matter how many yen the Bank of Japan pumps into the system. China’s Shanghai Stock Exchange Composite Index is down 22% year-to-date. Japan’s Nikkei 225 is down 16%.
Investors around the world have little appetite for risk. Bloomberg reports that $7 trillion, or roughly 30%, of all sovereign bonds yield negative rates today. Wide swaths of investors aren’t even seeking return. Instead, they’re paying to have their cash warehoused.
In this environment, one big-name bond default or one big-name energy bankruptcy is all it could take to produce a worldwide market meltdown. With fear running so hot, what’s an investor to do?
You could be preemptive and sell everything. The problem with that strategy is that we could be near a bottom and stocks could begin to trend higher. And even if it’s not a bottom, how do you know when a bottom is reached and when do you reload on stocks? Selling and going all to cash is a scorched-earth strategy that I don’t recommend.
Hedging is a more reasoned approached. Contra assets – assets that move counter to your investment portfolio – limit volatility and mitigate downside risk. Inverse ETFs can serve as a useful contra asset. I explained two months ago how investors can hedge their portfolio with inverse ETFs.
Precious metals have a long history of mitigating stock risk. The negative correlation holds to this day. The S&P 500 is down 10% year-to-date. Gold and silver are up 11% year-to-date. You can gain exposure to both metals on the cheap through the Central Fund of Canada Ltd. (NYSE: CEF), another contra asset I wrote about.
If you’re a disciplined investor, standing pat just might be the most reasoned approach of all (especially if your portfolio is full of “forever stocks”). Bear markets can be brutal. The S&P 500 has retreated 40% on average during bear markets. Forty percent (or very possibly more) is punishing, to be sure, but punishment tends to be swift and short. Most bear markets last fewer than 18 months (again, on average).
Capital structure is the key to survival. I refer not only to a company’s capital structure, but to your capital structure as well.
U.S. energy companies aren’t in trouble solely because of low oil prices. They’re in trouble because of low oil prices coupled with high debt loads. Debt always amplifies return; it always amplifies risk. No matter how plentiful and cheap, debt must always be serviced, regardless if the cash is flowing in to service it.
What applies to a company applies to you. If you’re in debt and if you used debt to purchase investments, you’re in trouble when prices begin to fall. If you want to stay in the game and build wealth over time, take the unleveraged route by investing only money you have on hand. You’ll not only save yourself many sleepless nights, you’ll make more rational investment choices while awake.
What’s more, if you’re liquid and unleveraged, you’ll likely have cash on hand to invest in the value-priced remnants once hell is again contained.
How to Sleep Easy at Night
Is the economy keeping you up at night? Do you worry there’s another crash just around the corner? If so, you can stop worrying right now. All it takes is a few minutes.