In September of 2012, the central bank of the United States (a.k.a. “the Fed”) announced its largest debt-buying policy ever. The $85-billion-per-month endeavor sent mortgage rates to amazingly low levels. Real estate purchases soared, property prices rose sharply and homeowners became enamored with “3.4% Fixed for 30 years.”
Naturally, the central bank hoped that its manipulation of interest rates would inspire conspicuous spending. Yet that’s not all that the Fed managed to electrify. Ultra-low rates also encouraged titanic risk taking in the U.S. stock market. Since September 2012, U.S. stocks have increased in nine out of the last eleven months. Similarly, the U.S. stock market has not experienced a pullback of 10% since the Fed publicized similar bond-buying promises in September of 2011. That’s 23 months and counting.
In the shorter-term, Federal Reserve stimulus via quantitative easing (QE) has helped to enrich many people’s finances. With the uptrend continuing, I’ve made certain to keep my clients allocated to a wide variety of U.S. stock ETFs including, Vanguard Dividend Growth (VIG), iShares Russell 1000 (IWB), PowerShares Pharmaceuticals (PJP), iShares S&P Small Cap 600 Value (IJS) and UBS E-TRACS Alerian MLP (MLPI). Our stop-loss and trend-following methodology will determine when to lighten up on core holdings.
In the longer-term, however, an addiction to extremely low rates is going to very difficult to break. In fact, I am not convinced that Americans will ever be able to do it. We may wind down QE 3… only to see our Fed announce QE4 in late 2014.
Next page: 5 stock market hurdles
Rate addiction is one of 5 things that could put a significant damper on stock market enthusiasm. Here is my list (in no particular order) of things that could sink U.S. stock ETFs:
- The “Tapering.” Many believe that our central bank is in the process of winding down its bond-buying program. That speculation led to a swift June sell-off in rate-sensitive assets like bonds and preferreds. More worrisome, the “3.4% Fixed for 30” is now “4.4% Fixed For 30.” Will investors or families be enthralled with 5.0%? 5.5%? 6.0%? Chances are, we’d see QE4 before that happens.
- Economic Growth or Stagnation? The media spin on the well-being of the overall U.S. economy is peculiar. Expectations of exceptionally low growth are routinely surpassed, exciting the investment community. The fact remains, though, that 1% average growth over the last 9 months is dismal. The stock market can ignore economic reality for long periods of time, though it cannot ignore ultra-slow growth indefinitely.
- Oil Prices Holding Above $100 Per Barrel. There are times when the stock market has moved in lock step with the direction of oil prices. “Pain at the pump” has often demonstrated a potential to send stocks plummeting. Not today, perhaps. What if $107 becomes $117? $127? The price of crude could serve as a rude awakening.
- Are European Banks Cruising For A Bruising? Political scares from Portugal to Italy to Greece continuously threaten the bailouts, aid and/or tenuous agreements that exist. If respective countries do not receive European Monetary Union help, scores of banks could be left overexposed to those country’s toxic debts. Moreover, the precedent-setting confiscation of deposits in Cyprus still could cause depositors to pull money out of other European banks.
- Overvalued and Overbought. There are plenty of reasons to be critical of stock valuation tools like the 10-year cyclically adjusted PE Ratio (a.k.a. PE10 or CAPE). That does not mean it is useless either. The 10-year price-to-earnings ratio for the S&P 500 stands at 25, not far from the 27 reached in October of 2007. This hardly constitutes a sell signal by itself, but it should be cause for reflection. In a similar vein, stocks gained ground on 19 out of the last 24 trading opportunities; similarly, the S&P 500 SPDR Trust is more than 10% above its 200-day moving average.
Naturally, I could have listed more reasons such as the upcoming debt ceiling debate or waning corporate sales. On the other hand, stop-limit loss orders and/or simple moving averages like the 200-day provide enough cover for reducing exposure to U.S. stock ETFs. The bigger question is what to do with additional cash. Rather than add more of the same, I am pursuing assets that have been less correlated with the U.S. stock market over the last 6 months.
For example, Vanguard FTSE All-World Excl U.S. Small Cap (VSS) has had a negligible correlation with the S&P 500 and with the Russell 2000 over the prior 6 months. By itself, it may appear vulnerable and volatile. In the context of a well-diversified portfolio, though, it may provide capital appreciation as well 4% annualized income. If purchasing the asset, be sure to understand under what conditions you might sell it.
Gary Gordon is president of Pacific Park Financial, Inc.