As an investment adviser, one of my jobs is to stay informed of economic conditions and how they can affect my clients’ current investments and create opportunities for future investments. I am by no means an economist, but I read what many of the top economists and money managers are saying/writing about the economy. Because I am so passionate about finance and investing, I read about those topics quite frequently throughout the day.
For at least the past couple of years, many of the top economists and money managers have been concerned about the U.S. stock market (currently near an all-time high) and U.S. bond market (also near an all-time high with record-low interest rates). I’ve written before about the uselessness of most forecasts (two different links), and I believe that forecasting is more like reading tea leaves than providing something that one can clearly rely upon. That said, here is a run down of some of the most prominent concerns:
- The interest rates on bonds both in the U.S. and abroad are at all time lows. In some countries, the interest rate is negative, meaning that you are paying interest to loan your money instead of getting interest back. This causes significant harm to insurance companies, banks, pensions and retirees, and is forcing money into the stock market as people seek some return on their investment. Many believe that the central banks are making a huge mistake with interest rates this low.
- When long-term interest rates become lower than short-term interest rates, then the “yield curve” has “inversed”, which basically means that people are really concerned about the long-term state of the economy, and it is a fairly accurate predictor of an upcoming recession. The yield curve is not currently inversed, but some believe that when adjusted for the federal reserve’s intervention, the yield curve is essentially inversed.
- Most countries have used all of their best monetary (i.e. interest rate policy and quantitative easing) options, but they have not been able to put together any real fiscal stimulus, which may be much more effective right now, especially if we enter into a recession.
- Most of the valuation measures of the U.S. stock market, such as CAPE, Tobin’s Q, and P/E, all indicate that the U.S. stock market is very overvalued. Further, we are currently in an earnings recession, so the “earnings” part of the P/E ratio is still going down, driving many of those ratios even higher. When the market is overvalued on a historical basis, then usually that means we will have poor returns for the next few years.
- Finally, there is significant geopolitical risk from China, Russia, Brexit, ISIS, Zika and so on. Although the U.S. stock market rebounded nicely after the Brexit vote, there is no guarantee that the next bad event won’t trigger a crash.
Some of the forecasting methods mentioned above have proven to be fairly accurate at predicting investment returns over the next 5-10 years, but as I have mentioned before, we are in such a unique situation economically, and we have no great historical comparison to the present situation, that what has happened in the past is not necessarily indicative of what will happen in the future. Further, even if these indicators are correct, and the U.S. stock market and U.S. and foreign bond markets are significantly overvalued, it is not possible to predict if or when those markets will have a significant decrease in value. In fact, many are predicting that because of intervention by the Fed and its foreign government equivalents, rather than experiencing a significant bear market, we will just have many years of poor investment returns while the value of these markets catches up to their inflated prices.
So what do you do if you are concerned with the US stock market, or any other market? The answer depends on many things, but consider the following:
- If you are concerned/scared/nervous that your investments will decrease in value, then you are likely taking on too much risk. You can resolve it by either a) decreasing your risk; b) hedging against your risk (which I generally advise against) or c) using an objective measure of an investment’s performance as a trigger to sell some of your investments, such as when the investment’s price drops below its 200 day moving average.
- Rather than simply decreasing your risk, it may be possible that you need a different investment methodology that better fits your risk tolerance and goals. Before taking any drastic option, it is preferable to consult with an independent investment adviser, even if on an one-time, hourly basis, to make sure that the methodology makes sense.
- If you have a long-enough time horizon, and your investment methodology and execution of that methodology is appropriate for your risk tolerance, then turn off CNBC and the blogosphere (except this blog), and perhaps just ride it out while dollar-cost averaging and tax-loss harvesting.