In September 2012, the central bank of the United States (aka 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, stocks have increased in nine out of the last 11 months. Similarly, the U.S. stock market has not experienced a pullback of 10% since the Fed publicized similar bond-buying promises in September 2011. That's 23 months and counting.
In the shorter term, Federal Reserve stimulus via quantitative easing 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 the Fed announce QE4 in late 2014. Rate addiction is one of five 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 years" is now "4.4% fixed for 30 years." 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 nine 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 lockstep 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 those respective countries do not receive European Monetary Union help, scores of banks could be left overexposed to those countries' 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 P/E Ratio (aka P/E10 or CAPE). That does not mean it is useless either. The 10-year P/E ratio for the S&P 500 stands at 25, not far from the 27 reached in October 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 six 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 six 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.
Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.