If we are closer to a top and we start seeing early signs of a correction, it’s important to adopt a defensive investment strategy before a more serious crash occurs.
The market may still reach new highs, but the risks are mounting. Personally, I’d rather sacrifice a bit of performance to protect the downside.
The reasons why we want downturn insurance in place now are:
Stocks still have rich valuations today, especially the FAANGs. P/Es are high compared to historical averages.
Over the last several years, corporations have used leverage for financial engineering rather than boosting productivity.
US corporate debt levels are at an all-time high (above $6 trillion or about 31% of GDP). This excess leverage is fine when interest rates are low, but it can be deadly in a recession. In addition, stock repurchases don’t have the same impact on profits than capital investments.
Interest rates are expected to increase as a result of the Fed’s tightening policies. Treasury issuances will likely increase over the next few years. Unfortunately, this may coincide with lower demand for US debt from both international and domestic buyers.
Higher interest rates will put pressure on demand for consumer goods and real estate. These are two critical drivers of economic activity in the US.Many asset categories are currently in bubble territory and prone to downward adjustments: growth stocks, bonds, real estate in many markets, arts, collectibles, and luxury goods, and cryptocurrencies.
Geopolitical risks are not insignificant (North Korea, Iran).
Political gridlock in the US could lead to paralysis after the mid-term elections.
Heightened risks of protectionism and trade wars.
There are some positive indicators that could prolong the current expansion—such as high employment rates and robust economic activity in all the developed economies.
The Trump administration’s tax reform could also boost the economy, although most of the benefits are likely to be delayed.
As far as I am concerned, starting in 2017, I have started adjusting my portfolio to get ready for a sizeable correction. I haven’t sold all my stocks and bonds, of course, but I have rebalanced the asset allocation considerably.
For example, I’ve sold overvalued positions and added a lot of cash to redeploy once the correction hits. And I have purchased a significant amount of gold during the last 12 months—both as insurance and because it is a non-correlated asset class that also happens to be quite inexpensive right now (learn what type of gold is best for you here)
In addition, I have made a few long-term leveraged bets on a market correction.
I recommend you do the same.
This article was republished with permission from Peak Prosperity.