Where to hide in the stock market?
The stock market has given up gains for the year. The economy is holding up strong: employment data came in above expectations. But confidence in the markets is shaky as crypto rot has spread to the Silvergate Bank . Then the Silicon Valley Bank imploded as it was trying to patch up losses realized in its bond portfolio through a fund raise that quickly has turned into a run on the bank and complete shut down. Drama, drama…
Now everyone is anxiously awaiting CPI numbers this Tuesday, March 14th. A stronger than expected CPI number might send the market downwards further in search of new lows as the FED will be expected to raise interests rates even higher to slow down the aggregate demand. There is a talk of 50bps rate hike being back on the table at the next FED Interest Rate Decision on March 22nd. The last hike was 25bps.
DO YOU KNOW WHERE THE ECONOMY AND THE STOCK MARKET ARE HEADING?
There is no clear direction for the economy or the stock market. Up ? Down ? Arguments are being made in both directions.
Middle road: sideways with spikes of volatility sounds about right. We are sort of in the purgatory.
Here are some major points to bear in mind:
- Most economists / investors expect a minor recession later this year. Currently, there is (yet) no systematic risk to the financial system unlike the 2008 Financial Crisis that started in the real estate market.
- Strategists point out that the earnings expectations have not fully re-rated yet and once that point sinks in, the market will look for the new lows.
- Historically, the stock market returns to growth once the FED stops the rate hikes or reduces them. Also, the stock market usually bottoms out a few months before the FED halts the rate hikes.
- The War on Inflation is going to be longer than the stock market recover from the pandemic. Hence, the FED will have to hold the rates longer.
- As the the money supply contracts and the FED rate hikes reduce the availability of credit in the markets, there should be an impact on the labor market that we have not seen yet. Construction employment numbers are still positive… That means that despite the 30-year mortgage rate being at 6.7%, there is still (some) optimism in the parts of the real estate market.
- The speed of the FED rate hikes have been very fast. It has a huge effect on the bond portfolios as bond prices tanked as yields rose (that is what killed SVB; need for liquidity forced them to sell bonds at lower prices that resulted in a $1+bn of losses). Other such surprises can come out of the blue. Fortunately, most major banks are well capitalized after the 2008 Crisis but the smaller ones are less so. While not systematically critical such implosions will shake the investor confidence.
FAQ FOR INVESTORS
Is the stock market going to zero?
Very unlikely, as it will would wipe out the entire financial system, retirement plans an would lead to a civil unrest (which we might have either way).
Just think about that: $32 trillion is stashed in the retirement accounts in the US. 401ks, IRAs, etc. that are invested in the financial markets.
US GDP is about $26bn (https://fred.stlouisfed.org/series/GDP) at the end of 2022.
Can the stock market drop down another 20%?
Yes, it can as we are coming off a very hyped-up valuation environment that was driven by low interest rate environment through which the FED fought the deflationary pressures that globalization brought across the world.
Note on the chart below that P/E multiple (aka Price to Earnings ratio) has been above 40x in 2020/2021. Now P/E is at 21x per Quandl data but historically it has been around 13–15x. Also, worth noting that during the inflationary environment of 1970s-80s it was as low as 6–7x. The deflationary period of 1990s-2020 has been a lot higher.
With S&P500 now near 3,850 and P/E ratio of 21x, the market is expecting $183 in earnings for the year. As inflation can eat into the companies earnings, those earnings expectations can go down further.
As the era of globalization has already peaked and there is a growing resurgence of nationalism and protectionism, the deflationary period might give way to inflationary. Companies are now looking to be less dependent on production in China and more eager to set up manufacturing near their own shores. Setting up factories in North America is more expensive than in Asia and that will drive up inflation. “Near-shoring” is the new cool kid on the block.
Thus, as you think about the prices and valuations it is worth factoring in the deflation/inflation into your calculus. What has been a norm over the last 20 years, might not be the same going forward.
Where are we in the economic cycle?
It is worth considering where we are in the economic and the credit cycle as it will help you figure out where the stock market sentiment is.
Take a look at the Sector Rotation chart below that shows the economic and the stock market cycles. Notice that the economy in the full recession swing is also the start of the stock market’s bull cycle that that is usually when the FED starts to cut rates.
This chart from Fidelity below shows what sectors are likely to perform well during the each phase of the Business (Economic) Cycle.
Notice that as the economy moves into a recession, the stock market favors Consumer Staples, Health Care and Utilities. We are right now between the Late part of the Business Cycle and the Recession (aka Purgatory).
You will notice how the market is acting, if you observe it over a period of time. For example, on Friday, March 10th all indexes went down but some sectors (ETFs) have gone done less than others. Compare the table below to the Sector table from Fidelity and you will see that they line up fairly well. On Friday, the investors were positioning for an incoming recession.
You can do a similar analysis over a period of time to see how the sector performance turns out.
Is is better to invest into funds (like ETFs or Mutual Funds) or into individual stocks?
- For the majority of investors it is definitely better to invest into ETFs as you get a diversified exposure. Robo-advisors offer portfolios structured from 10–20 ETFs. Pretty good way to track the market.
- When selecting ETFs, you can use an ETF comparison tools like https://etfdb.com/ ; note how much assets the fund has (the more, the better as better liquidity), and what the expense ratio is.
- Picking individuals stocks can be exciting but there is a risk the company can go bankrupt. SVB was trading above $760 in November 2021 and now it is gone.
- When picking up individual companies, make sure you pick the ones that are cashflow positive, with strong balance sheets (not too much debt) and keep in mind that the dividends can be cut once the recession kicks into full gear.
How to find stocks to invest in?
Each investor has its own methods. Investing into companies that are currently in the news is rarely a good idea. However, if you do want to invest into ‘trendy’ stuff, it would probably be more prudent to invest into trends (remember FANGS?) through an ETFs focused on it (Cathy Wood’s Ark Invest created such ETFs). Generative AI is the current hot topic.
If you want to invest into individual stocks over time, you might want to consider the following exercise:
- Create a few watchlists for each of the main sectors
- Find the major ETFs for each sector; then go to the “Holdings/Portfolio” section of the sector and add them to your watch list. Someone has done the work for you of picking up major companies in the sector.
- Set up a screening table (i.e., in Yahoo Finance) so you can view things like the market cap, valuation multiples like EV/EBITDA, P/E, profitability: EBITDA and Net Income margin / Cashflow, leverage ratios like Net debt / EBITDA and dividend per year, dividend yield, etc.
- As you observe your watchlists over time, you will see how these companies perform relative to the major indexes (and its own ETF). Strong companies will be able to withstand an economic downturn even if they might reduce dividends along the way.
Questions to ask yourself when making investment decisions:
- How much time do I have to devote to tracking and managing my portfolio? If you cannot be bothered, use a robo-advisor service that does all the work for you.
- Am I investing for a short term or long term? if you might need money next year to buy a new house, probably avoid taking too much risk and invest into things that are solid and are not too volatile.
- How much should I invest from each paycheck? Making it a regular habit is key. Set up an automatic investment from each paycheck and you will benefit from dollar cost averaging.
- How much risk am I comfortable with? What lets me sleep at night? Can I sleep soundly if I put all my money into a hot meme stock that can go up 10% in a day? but it can also go to zero overnight? More risk usually leads to a higher potential return.
- What do I invest in? a group of funds (ETFs or Mutual Funds)? select individual stocks? bonds or notes?
- How does my investment portfolio tie in with my 401k or IRA and my other investments like real estate or crypto? how are they correlated?
- Should my investment strategy change over time?
Isn’t this fun? Have a blast!
