For the Federal Reserve leadership, life can be like the world of physics particles; it is impossible to look at something without changing it. The Federal Reserve Chair looked at current stock valuations, and she was not able to avoid changing it. The investment world does not stop, and this is true even when it is clearly time to simply listen. Federal Reserve Chair Janet Yellen responded to a question about valuation of stocks and securities. Her comment has caused reactions in the markets that likely exceed anything she wished to communicate; stocks and government bonds fell, and bond yields rose. She estimated that the market seems to be within normal ranges, and stock valuations seemed high or fully valued. Perhaps the difficulty is in determining whether there really is such a thing as normal ranges.
The Current State of the Markets
By the usual measures, the market is strong. The Dow Jones Industrial Average is near its all time high of 2,117.69, and the S&P 500 trades at a solid ratio of about 18 times earnings. The U.S. economy is relatively stronger that those of Europe, China, and Eastern Europe. Energy prices, often a driver of volatility, are stable and showing resilience. Inflation is within Federal Reserve target ranges. Employment data and economic growth statistics suggest a flattening the growth curve but at levels that suggest only a temporary softening. However, this is the time to prepare for change, rather than after markets begin to move in unpredictable ways. As we previously advised, the best time to prepare for volatility is to always be prepared for the next bubble.
Low Bank Rates Environment
The difference maker in assessing the market today is the low level of interest rates. That is the key to understanding Yellen’s remarks and the current market. Valuations are related to interest rates and as interest rates rise valuations may be affected. Her concerns are that large banks will pursue risky ventures to reach for yields rather than serving needs of economic growth such as innovations and job growth. Expert analysis tended to agree that the rate of interest rate increase is the key. A very gradual line will likely have little real impact on valuations. However, the markets may respond otherwise.
Hedging Against the Next Bubble
The market can interpret a decision to raise interest rates above the near zero level as a first step in a strategic pattern. The overall effect of market reactions can be unpredictable, and it can lead to market volatility. Unlike the fall of energy prices in the second half of 2014, this type of volatility can be widespread; it may follow trends such as moving away from investments in stocks that experts rate as possibly overvalued. Diversification is a primary tool when hedging against volatility, and investors could adopt many reasonable strategies to guard against falling stock and bond values.
Ready to Move Against the Market Direction
The strength of planning for falling markets is in preparing an action strategy and arranging assets for useful advantages. In a volatile market, bonds and stocks may fall simultaneously. As investors leave holdings, buyers can find valuable assets among falling prices. The stocks which now cause some concern over valuation in the range of 18 times, as the long term median is about 15. The stock prices may improve for buyers in a falling market, and offer opportunities to buy for short and long positions. In order to take advantage of this market, one may move some holdings into cash. One can also move stock holdings into mutual funds that pay significant dividends and emphasize profits. Current cash reserves could remain at the ready or in liquid investments which are easily and quickly convertible to cash.
Look for Trends
In a falling market, there may be islands of investment growth. One should look for growth areas among stocks such as tech innovations and follow news events. One example is the recent announcements for electricity storage systems by Tesla. Companies that prove to have remarkable innovations can rise in a falling market, and offer long-term growth potential. One can exercise greater selectivity in stock purchases. In a falling market one can look to investments that have shown resistance to volatility. One should consider indexes like the S&P 500 Dividend Aristocrats that offer excellent payment performance over many decades.