After remaining resilient during the summer financial storms that brewed around the globe, the U.S. equity markets fell into correction territory in late August. A pending, albeit uncertain, interest rate hike and concerns regarding an economic slowdown in China are heralded as the most significant drivers of fear. Nonetheless, the systemic issues in the equity markets could result in a bear market. An examination of the current agents of uncertainty and the underlying fundamentals propping up the bull market make a case for diversification.
Factors Driving the Correction
Prior to the current market meltdown, the Fed liftoff date was widely anticipated to be in September. The question becomes, “Will the Fed move forward or attempt to appease Wall Street through another delay?” Since World War II, the Fed has initiated 16 rising interest rate cycles and the S&P 500 has decreased by at least 5 percent in 13 of those cases. Assuming rates begin to rise within the next six months, the record will move to 14 in 17 instances. It can be argued that the interest rate hike is already priced into the market, and the underlying economic fundamentals remain sufficiently strong to suggest rates will liftoff in September or October.
However, Janet Yellen’s Fed is notoriously dovish and FOMC minutes have previously indicated the central bank will wait until nearly every metric is favorable rather than a considering the preponderance of available data. Low wage and inflation growth, coupled with a market correction, may provide enough fodder to put the brakes on normalizing monetary policy until 2016. Nonetheless, the job market remains strong and auto sales are on a near-record pace. Furthermore, the housing market is healthy across the country. Despite pressure from Wall Street, the federal funds rate is anticipated to get off the floor no later than October if August’s job growth figures reach expectations.
The issues surrounding China are shrouded and run the gamut from how weak the world’s second largest economy has become to the level of contagion that it could inflict on the U.S. China’s GDP growth has been slowing for five years despite attempts to add stimulus. Additionally, the amount of support by the People’s Bank of China to prop-up an overvalued equities market likely indicates the economy is on worse footing than previous thought. That theory is supported by the PBOC’s surprising move to devalue the yuan, making exports more attractive. A combination of heavy-handed government intervention and a weakening economy may pull capital out of the country, particularly if the Fed raises rates in short order.
Factors That Matter
Beyond the issues in China, a number of factors could turn the correction into a bear market, though they would likely need to work in concert with one another. Rising interest rates would send a flood of capital back into the U.S. dollar and Treasurys, making it more challenging for emerging markets to meet debt obligations. Margin debt is also elevated, and the ratio of margin debt to free cash is at the highest level ever. Simply, a smaller slump in the stock market is necessary to issue margin calls and send the market into bear territory. Corporate stock buybacks fueled by low interest rates are also at new heights. Stock repurchases have sent earnings per share soaring, artificially inflating the health of many firms and sending equities higher. A normalized monetary policy in which companies issue stock to raise capital rather than borrowing money would unveil weaknesses and drag prices down. These red flags indicate a chance of a bear market is higher than any time in recent years.
Preparing for a Bear Market
Diversification is key to insulating investors from turmoil in the equities market, particularly at times like these. Although financial experts suggest that the stock market is a long-term play, investors will need to re-examine their portfolios to determine the portion of their investments that can ride out the storm. After the 2008 bear market, the ensuing bull market took four years to recoup losses. Adding the period of the bear market, investors spent nearly six years in the red during the last downturn and witnessed 50 percent of their nest eggs evaporate in the darkest times. Real estate, including single-family rentals, offers investors a true hedge against bear markets while providing stable and substantial monthly returns.
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