The stock market has been on a wild ride this year and it seems that everyone wants to jump on the train. The market gained +15% in 2019 and reached its highest since 2011. Many experts are now warning that this year’s rally may not last and the stock market could see a major decline.
Last year was a major reversal from the previous one. The 2017 – 2018 market decline was unprecedented. The S&P 500 SPX, -1.56% dropped by more than -20% and many believe that the only way the market can recover is by going through a severe downturn. Many experts are now expecting a total collapse in the coming months and even years. They are calling this the ‘global recession.’
Many market observers believe that the only reason why the S&P 500 managed to avoid a total breakdown last year was due to monetary easing and central bank stimulus. Interest rates have been at all-time lows for almost a decade and traditional safe havens like gold and bonds suffered significant damage as a result. The Federal Reserve has also been buying stocks since March 2009 as part of its asset purchase program. The central bank may have saved the day by printing more money, but it also kept the market on life support.
Interest Rate Risk
With interest rates at such low levels, it is hard for most investors to avoid being impacted by changes in the economy. When the Federal Reserve raises rates, as it has done five times since December 2008, it causes havoc in the stock market. The Fed’s tightening cycle is known as the ‘rate curve.’ When the Fed decides to hike rates, it usually begins with a 10 basis point increase at the beginning of the year and then another five or six basis points at some point in the second half of the year. After the rate hike, traders in the market usually want to take profits quickly before the bad news spreads even more and the Dow drops further. When this happens, sharp declines are often the result.
This can cause a lot of problems for investors who are still in the market. Short-term rates have been at historically low levels for a long time and even the long end is behaving erratically. Bond prices have gone virtually nowhere since 2014, while the long end of the curve has seen a steady climb. While long-term rates have increased by less than 10 basis points in the past year, the most recently issued 10-year Treasury notes TMUBMUSD10Y, 0.683% have seen price increases of nearly 20 basis points. The combination of an inverted yield curve and a major spike in long-term rates is a recipe for disaster for many speculators and short-term traders in the market.
Monetary Policy Risk
Monetary policy risk is the risk that a central bank will set a poor course of monetary policy. The Federal Reserve’s track record over the last 10 years is dreadful. After slashing rates three times in the middle of the last decade, the Fed has decided to raise rates five times since Dec. 2008. This has been the complete opposite of what practically all experts were predicting prior to the 2008 financial crisis. This makes the Fed’s economic forecasts very unreliable. The Federal Reserve is also known for being inconsistent when it comes to policy. Raising rates in December 2008 and then cutting them in June 2009 was an example of this.
The problem is that when the Federal Reserve raises rates, it usually does so for a specific reason. The central bank will often point to the state of the economy and lay out the reasons why it is raising interest rates. However, there is no consistency to this. Economists and industry experts often disagree on the Federal Reserve’s reasoning and the overall direction of the economy. Few can predict what the Fed will do next or if it will even maintain its current course of action. This makes it very hard to place precise bets on the market. You just never know what your odds are going to be when you sit down to place a trade.
Even when interest rates are stable, credit risk is always a major factor in the financial markets. When the economy is doing well and businesses are hiring, customers have more money to spend and this increases the demand for goods and services. Banks and credit card companies love to lend out money. During good times, everyone wants to borrow money to make purchases or to invest in businesses that will generate income in the future. This makes interest rates fairly low and the market highly accommodating of new customers. Credit risk, which is the risk of default or non-payment on a loan, increases during bad times. If a business cannot make its payments, the lender will want their money back. In most cases, this means the business will have to close its doors. If this happens during a recession, it can cause a lot of collateral damage to the economy.
This is the main reason why the stock market has dropped so much in 2019. When businesses and individuals want to borrow money, they often turn to the market for credit. As the economy improves and businesses receive enough cash flow to make payments, the demand for debt falls. This trend is especially apparent in corporate America where fewer businesses are using credit cards and more are turning to equity capital. In most cases, businesses will not want to expand when they have no cash flow. This is why the market began to decline in Q4 2019.
Value Investment Risk
Another major factor that influences the value of a stock is the company’s future performance and whether it is actually worth what is being paid for it. A value-added investor will almost certainly be affected by the news headlines and the economic indicators that form the basis of broader investment analysis. In most cases, a value-added investor will ignore the price paid per share because they are concerned with whether or not the business is going to be worth the money invested in it. This type of investor will want to see strong company earnings and a rise in share price as signs that the business is valuable and worth the investment.
Since value-added investors do not mind taking a little more time to build a long-term holding in an attractive business, they tend to be more protective of their wealth. When stocks decline in value, it often causes a mass exit from the market and a major retracement of the previous year’s gains. In most cases, the reverse is true and value-added investors are usually well protected by the structures and strategies they use.
Inflation, or the rapid increase in the cost of living, is another factor that can cause significant damage to an investment portfolio. During periods of high inflation, investors will want to protect their purchasing power and buy assets that will retain their value over time. Since most forms of investment, especially securities, are designed to increase in value, high inflation will usually cause stock prices to fall. As people get worried about the cost of living and the effect it will have on their wallets, they will dump their investments in favor of assets, like gold, that will not be affected by rising prices. In most cases, very high and persistent inflation, as we have seen in the last decade, causes severe damage to the economy as a whole.
While inflation as a whole is a risk factor that every investor needs to be aware of, there are certain asset classes, like real estate, that are more likely to be impacted than others. If you are purchasing a home, you are probably going to be feeling the harmful effects of inflation, as average home prices have risen by more than 30% since 2011. A safe haven for investors during periods of high inflation is real estate, precious metals and international bonds. Stocks are also a safe haven for many investors seeking capital gains, but for different reasons.
Speculation, or trying to guess or ‘figure’ the direction of the market by taking on large positions in hopes of capitalizing on small up or down movements, is a high-risk strategy that many investors use. A large number of speculators will buy and sell stocks and other financial assets as a hobby, or as an activity that offers better than expected returns for people seeking quick profits. The problem with speculation is that it is all about trying to guess the direction of the market. During good times, speculators will make a lot of money. However, during bad times, speculators are usually the ones who suffer. When the economy declines, people tend to lose interest in day-trading and focus more on the long-term, where the majority of the money is made. Since speculation is a high-risk strategy, it is not suitable for everyone. However, for those who seek the thrill and excitement of day trading, it is a risk-tolerant investment approach.