Crash: Not So Sure. Correction: Sooner Rather Than Later

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Includes: AAPL, CAT, DIA, DWDP, GE, GILD, HD, IBB, MRK, PEP, QCOM, SPY
by: Gonzalo Camina

Summary

U.S. markets are on the verge of a significant correction, whether this correction turns into a crash or not is a matter of human behavioral psychology.

The stronger dollar and the imminent hike in rates are just two of the factors signaling the downward adjustment in the U.S. equity and bond markets.

Taking some profits and holding cash might be the optimal strategy for the upcoming months.

There are many visible factors that are signaling a correction in the U.S. equity (and bond) markets (SPY, DIA), in the near future. Whether this correction turns into a crash or not is a matter of human behavioral psychology, a body of knowledge a little too far from my area of expertise. In any case, it would be a good idea to reposition your portfolio in order to protect it against the imminent adjustment, and also to have buying power once the markets find a bottom.

I want to clearly state, that I am not trying to predict the next global financial crisis, I am, however, analyzing the current situation and recognizing that the probability of a downward adjustment is at its highest since 2007.

Stronger Dollar

If at the beginning of last summer you asked any Forex analyst at any investment bank, or small boutique, where did they see the greenback in a year, not a single one would have said that 1 dollar would be worth €0.90 euro, I repeat: not a single one. Remember that one year ago one dollar was worth €0.73. The gain represents a whopping 23% for the buck. Analysts are now quick to assure that parity is possible before the end of 2015… What a forecast!

(Source: XE.com)

A stronger dollar means that the companies that have most of their debt denominated in this currency, but a large amount of revenues in others, are going to suffer lower earnings than the ones forecasted, we can find pretty big names among the companies suffering this situation: Apple (NASDAQ:AAPL), Caterpillar (NYSE:CAT), du Pont (DD), or General Electric (NYSE:GE), have warned about possible headwinds and/or cut their earnings guidance. The bond and equity markets are already experiencing the consequences, and they will probably feel them even more in the following earnings seasons, especially when the policy divergence between the U.S. and the rest of the world keeps on feeding the dollar rampage.

Tightening of monetary policy

This one is a no-brainer for anyone that has notions on valuation. Let's show why the hike in interest rates will result in cuts in the current equity valuations all across the board. What is the most used method to value investments in Wall Street? DCF. What is the present value (discount) factor in DCF? WACC or cost of equity. What would increase these values? Higher interest rates (higher risk free rates)... This is why the hike on interest rates will have an immediate impact in the U.S. equities valuations, and a pretty fast reflection in their prices on the exchange.

Turning to the bond market, when the Fed hikes rates, banks will adapt and start issuing debt that offers higher returns to the bondholders. Who is then going to buy a bond at the same price as a new one that offers a higher return? No one. The old bond's prices will adjust, which means they will drop. This is why we might see the correlation between prices of bonds and stocks higher than it has historically been, since the main driver of the imminent stock correction will also affect bond prices. For those bondholders that are holding to maturity or that have floating or putable bonds, the change in price will be reduced.

The tightening will bring liquidity to the U.S. (which at the same time will make the dollar strengthen even more) but this money will move towards the new and fresh issued bonds, not to the equity markets.

Overvalued growth perspective

The perspective of growth might be a "little" overvalued. There is a big slack in the market, huge, despite of what the politicians want to tell us. You might see the unemployment rate down, and in healthy levels, but when you realize that the drop comes from nothing more than a proportional drop in the labor participation rate… well, things turn a little less pretty. (You can read this great piece on the importance in the drop on the labor participation rate by David Houle: Why The Participation Rate Is More Important Than You Might Think.)

(Source: data.bls.gov)

(Source: data.bls.gov)

There is a factor in DDM and DCF models that takes into account the growth in the economy in order to calculate the future cash flows of the company and what is known as the Terminal value (which accounts for a humongous percentage of the whole valuation). If estimates of growth are overvalued, that, my friend, can be quite a problem. It will mean that all equities are overvalued.

Pharmaceutical and Biotech stocks leading the bull-run

Despite of the recent crash in oil and mining related stocks, the indexes have been able to keep on the bull-run on the back of a massive surge in technology and pharmaceutical stocks. It seems that we can't learn from the past. Just like in 2007, pharmaceuticals are attracting those investors that seem not to remember how unpredictable and uncertain the "miracle drugs" world tends to be. When the correction starts hitting us, sectors such as pharma or biotech can be responsible for a bigger than needed drop. Check out the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) performance chart. It looks rather overextended, doesn't it?

(Source: Fool.com)

But, what is going to prevent the biotech stocks to keep the party going for longer? there are a few reasons, two major ones:

  • Rate of innovation declining
  • Pressure on drug makers to start cutting on their profit margins

Number of buybacks

Many investors are now saying: "It's the time to buy, look at the number of buybacks in the market, if the companies are buying their own stock why shouldn't we? They are the ones that know best!" Investors that had this mentality in 2007 got smoked, big time. I do believe that this same mentality will condemn some people again, either this year or in the first half of 2016.

In the following chart you can see the level of buybacks in the S&P 500.

(Source: fortune.com)

Actually, stock buybacks announcements have increased by 50% from 2014 this year, so that chart is going to look even scarier at the end of 2015. Companies are now announcing buybacks at a record pace. Just to give some numbers:

Buybacks announcements for 2015

  • AAPL - $50 B
  • GE - $50 B
  • Home Depot (NYSE:HD) - $50 B
  • Gilead (NASDAQ:GILD) - $15 B
  • Qualcomm (NASDAQ:QCOM) - $15 B
  • Pepsi (NYSE:PEP) - $12 B
  • Merck (NYSE:MRK) - $10 B

Why are these companies buying huge amounts of shares back instead of using the cash for projects with positive NPV that would increase the value of the company for its shareholders? I think we are going to find sooner rather than later.

Exogenous Triggers

We are at a tremendously uncertain moment for the political landscape in Europe. The shift towards populist parties such as Syriza in Greece, Podemos in Spain, Ukip in England or Front National in France may already be hurting the much needed European recovery. The highest hurdle right now is Greece, with the troika having a really tough dilemma. In one side, Europe cannot give in to Tsipras demands, this would be setting a new standard and giving strength to the left parties all over Europe, but if Europe decides to go the other way, it faces the risk of a Grexit that will bring even more turbulence to the Eurozone, halting the European recovery, and possibly signaling the end of the euro.

Political uncertainty is not the only exogenous trigger that can bring the long expected correction. An increasingly unsettled and unstable international situation imposes risks that are really hard to understand and factor in equity and bond prices. The only sure thing is that tensions between different regions enhance the probability of market shocks, and that uncertainty is quite the enemy of the markets.

Just some more food for thought: The U.S. Economic Surprise Index looks rather pessimistic, right?

(Source: Bloomberg)

The signals are clear. The markets are telling investors to step aside and take some of the profits that they have been accumulating since 2008. Selling a significant percentage of the equities in your portfolio seems like the smart move. With negative inflation in three out of the four first months of 2015, holding cash doesn't hurt at all, and this cash will give you the flexibility that you are going to need when the downward adjustment plays out.

Disclosure: I/we 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.