The 4 Biggest Risks in the Market Today
This bull market started on March 9, 2009, which means it's just over 100 months old. That also makes it the 2nd longest bull market in history. The longest bull remains the 10-year run from 1990 - 2000, when the market gained 417% in 113 months.
With age comes increased risk -- the economy tends to experience lower growth rates, central banks start to tighten monetary policy, corporate profits start to dry up, and stock market valuations get stretched. We're already starting to see some of these symptoms today, so in my view investors should approach their investment strategies with more caution looking ahead. I remain positive for 2017, and think stocks have more upside available for the year. But there are four main warning signals that I'm watching most closely right now, that could very well determine when I turn bearish. Here they are.
Risk #1 - A Flattening Yield Curve
During the last two business cycles, stocks rose while the yield-curve flattened, but they eventually turned south once the yield curve inverted. Inverted yield curves generally portend economic slowdowns and recessions, because banks' profit margins get squeezed and it chokes off lending. The reason I'm watching the yield curve now is because it's been flattening over the last four years. That's not a great sign, but it's also not a case for bearishness today. On average, the yield curve inverts 16 months prior to economic recessions and 13 months prior to meaningful stock-market corrections. A yield curve inversion could be a ways off, but it's worth keeping a close eye on as this economic cycle matures.
Risk #2 - Monetary Tightening by the Federal Reserve
Every recession in the last 50 years has been preceded by a decline in money supply growth (to zero or below). This statistic is relevant today because the Federal Reserve is now in a monetary tightening cycle. The Fed has ticked up interest rates four times over the past couple of years (twice in 2017 so far), and language coming from Federal Reserve indicates that another rate hike could be in store for December. But that's not all - the Fed has also indicated that balance sheet reductions should begin in September. While the rate of balance sheet reductions could be very slow, taking 5+ years to reduce the Fed’s balance sheet to $2.5 trillion, it is still tightening across the board. How these actions affect corporate profits will be key to watch.
Risk #3 - Investor Complacency
Volatility has been notably low in the equities markets in recent months. In my opinion, that says two things: the first is that investors may be getting a little too complacent. Valuations are high, and stocks are pricey, yet they are still rising with historically low levels of volatility. Something doesn't quite compute. I think investors are getting a bit too cozy with risk, which may mean that latent risks are building in the market with few people noticing. The second thing low volatility tells me is that it won't last long - volatility tends to mean-revert, and in my view it is only a matter of time before the lull ends.
Risk #4 - Corporate Leverage and Credit Markets
In 2007, it was consumers that were overstretched. In the current environment, it may the corporate sector that is over-indebted, having long relied on debt to fuel sizable stock repurchases. Corporate leverage sits at a 13-year high, and delinquency rates are on the rise, and it’s been fairly broad-based. Auto loans have been particularly in the limelight - in 2009, $2.5 billion of new subprime auto bonds were sold. In 2016, that number rose to $26 billion.
But it’s not only auto loans that are turning sour. Delinquencies are rising across a variety of sectors, including consumer loans, commercial and industrial loans (many being energy-related), and agriculture. I'm not throwing up a warning sign just yet, but it’s important to note that rising delinquencies in these areas have historically preceded recessions.
In my view, investors should keep a close eye on these four risks as the year progresses, but for now I think they are in their early stages. The positives still outweigh the negatives in this market, in my view, so it's not yet time to trim equities and run for the hills. I'd say that cautious optimism is the right mindset.
