Markets Headed For Steep Correction

Includes: EEM, JNJ, PG, VCLT
by: Disruptive Investor


US markets can potentially correct by 15%-20% in 2014.

A record high margin debt indicates excessive levels of speculation in the market.

The US IPO market is flooded with new paper and valuations signal that the end of party might be in sight.

Dr. Marc Faber believes that the 2014 crash might be worse than 1987. According to Dr. Faber -

I think it's very likely that we're seeing, in the next 12 months, an '87-type of crash. I think there are some groups of stocks that are highly vulnerable because they're in cuckoo land in terms of valuations. They have no earnings. They're valued at price-to-sales. And this is not a good metric in the long run. This year, for sure-maybe from a higher diving board-the S&P will drop 20 percent.

Jim Grant also believes that the markets are at unreasonably high valuations. According to Jim Grant -

Since January, 2014, we have turned an unfriendly face to the market. We think the stock market is at a point where it is easier to find shorts than longs. There is more risk than reward as there are many candidates in the world for financial disruption.

Well established financial theory holds that the value of a common stock is future cash flows discounted by a suitable rate of interest. If the rate at which one discounts future cash flows is an artificially suppressed rate, it means the market is imputing a false value to the securities. Hence, the market is at a level at which it would not have been, but for these muscular central bank interventions.

I put these views at the onset as I am in full agreement with these opinions and I do believe that US equities can correct steeply in the foreseeable future. It might not be possible to assign a timeline to the correction, but the point is that the risk in the market is significantly high as compared to the potential for returns. It might be a good idea to avoid fresh exposure to equities at this point of time. I will back my conclusion with some indicators, which point to excessive speculation and high market valuation.

My first indicator, which serves as a red flag for the markets is the margin debt data. As of February 2014, the margin debt was $466 billion. This is a record level and is significantly higher than the margin debt just before the market crash in the 2008-09.

A record high level of margin debt is a clear indication of the level of speculation in the markets. With the kind of market correction witnessed over the last two trading sessions, it might not take long to create a margin call panic. This can accelerate the market correction. Very clearly, the market participants are not betting on fundamentals. There is a desire to make quick money leveraging on the flow of excess liquidity towards equities. The point that markets are not betting on fundamentals is clear when investors look at the valuation of IT and biotech stocks. LinkedIn Corporation (NYSE:LNKD) and Facebook (NASDAQ:FB) serve as some typical examples.

The second important point, which supports a steep correction thesis, is Jim Grant's point on markets discounting higher valuations as a result of artificially lower interest rates. Jim Grant's view is that since the rate at which one discounts the future cash flow is artificially suppressed, the valuations are artificially inflated.

I believe that the time has come for this to reverse. To back my claim, I would like to bring readers attention to the 10-year Treasury yield. Even after government intervention to keep yields lower, the 10-year Treasury yield has increased by 80 basis points since January 2013. In other words, the market participants are already discounting higher rates. In the near-term, the yields are likely to decline as markets correct. However, the long-term uptrend in yields is likely and equities will discount future cash flows at a relatively higher rate sooner than later. Valuations will then adjust downwards to more realistic levels.

I am also of the opinion that the IPO market is a good indicator of a potential market peak. When there is excess optimism in the markets, there is a rush of paper as companies seek to leverage on positive sentiments to attain higher proceeds. The total IPO volume in 2013 was $54.9 billion, which happens to be higher than the IPO volume of $48.7 billion in 2007 (before the market crash).

Further, the first few months of 2014 have been exciting for the IPO market with $16.7 billion of funds raised. The year-to-date activity in the IPO market is 81% higher than 2013. If this continues, 2014 might be one of the biggest years for IPO's. I however believe that this IPO bubble is also going to go bust in 2014 and companies will not come to the markets with unreasonable valuations after markets correct steeply.

I would like to conclude by saying that the current levels are not the best to consider buying equities. It is entirely likely that markets surge another 5%-10% from these levels. The risk-reward scenario is however largely tilted towards higher risk than rewards. Investors can therefore consider staying in the sidelines and investing on a potential 15%-20% correction. Stocks, which have given strong returns, can be considered for booking profits. Also, investors can consider exposure to relatively defensive stocks as a good switch from high beta stocks. I would personally recommend the following stocks and ETFs.

Johnson & Johnson (NYSE:JNJ): is a good long-term investment option. I like this highly diversified healthcare company with product as well as regional diversification. Further, the sector JNJ caters to is not very prone to economic shocks. JNJ has been a good dividend payer in the past, with a dividend yield of 2.7%. In my opinion, the stock is excellent for a long-term portfolio. It also commands a higher rating than the U.S. sovereign rating.

Procter & Gamble (NYSE:PG): - is another good stock in the consumer and personal care segment with a good dividend yield of 3.0%. I must mention here that PG has been an investor-friendly company having returned $88 billion to shareholders through dividends and share repurchase in the last 10 years. In terms of business growth, PG revenue contribution from Asia has increased from 15% in 2009, to 18% in 2012. Also, sales have growth at a CAGR of 23%, 25%, 27% and 17% in Brazil, Russia, India and China respectively in the last 10 years. Going forward, emerging markets will continue to be the growth driver for PG.

iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) - The iShares ETF corresponds generally to the price and yield performance, before fees and expenses, of publicly traded securities in emerging markets, as represented by the MSCI Emerging Markets Index. It is important to diversity the portfolio to emerging markets as the EMs have the potential to significantly outperform developed markets over the next few years.

Vanguard Long-Term Corporate Bond ETF (NASDAQ:VCLT) - I am suggesting the VCLT as I believe that quality corporate bonds are a relatively better risk-free investment compared with government bonds (especially long term). The ETF seeks to provide a high and sustainable level of current income through investment in high-quality (investment-grade) corporate bonds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.