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What Are the Warning Signs?

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Friday, July 24, 2015
Money and Markets
What Are the Warning Signs?
by Mandeep Rai

Dear ,

Mike Larson

The official Bull Market is still alive, although as you can tell by this week's market activity, the euphoria many felt over the past couple of years is in a bit of a lull. That has many people looking for signals as to whether the old bull still has some life in it or if we're heading for a correction.

Markets have rallied with few corrections since the recession and financial crises of 2007-09, which saw a market drop of up to 60%. We're probably not going to get such a collapse again soon, but there are some warning signs to be on the lookout for in regard to the market. Let's look at those current concerns and some ways to protect yourself:

* Companies are borrowing money at record levels to repurchase their own stock. NYSE margin debt levels are extremely high, which in the past has led to bursting bubbles.

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* We have a record number of unprofitable IPOs — companies are going public to access capital markets for funding, even when they aren't generating earnings. That's a risky and speculative game.

* Mergers and acquisitions are up 20% year-to-date, adding to the 101% rise in 2014. Inorganic growth could be a sign that a company's internal prospects have topped out and that management needs to scramble to purchase outside growth to satisfy near-term stockholder demands.

What are the warning signs to be on the lookout for in the stock market?

* The dollar is continuing to rise, and most analysts forecast further increases. A stronger dollar hurts larger companies with international operations, as it makes their goods more expensive compared with their foreign counterparts' output. About one-third of the total sales of S&P 500 companies are generated outside of the U.S.

* Earnings are slowing. Blame what you will — the weather, the dollar, global slowdowns, etc. — but the fact remains that the stock market is a function of the earnings of the companies in it. And even though companies are beating (lowered) expectations, absolute growth for both sales and earnings generation is troubling. If the market continues to rise, the math is simple — you'll be paying higher prices for lower returns.

* The overall price/earnings ratio is above average at 18.5x, but it's still a ways off from the early 2000 pre-crash ratio of 29x.

Add in geopolitical risks and a potential rise in interest rates, and the uncertainties just mount.

Does that mean you should just give up, get out of stocks totally? No, not really. There is still money to be made. You just need to play it safe: Study company fundamentals now more than ever and keep a good stash of cash to buy quality companies on any knee-jerk declines. These are all signs I watch closely for my Top Stocks Under $10 portfolio.

One investment that can help you protect against drops is an old-fashioned hedge: the put option.

Put options can be bought against the stocks you hold. If the stock's price falls, you have the right to sell your stock at the strike price no matter how far below that the stock actually declines. Of course, if the stock rises, the put option can expire worthless, but then you won't have to worry too much, as you'll benefit from the rise in the share price. Complicated? Yes. But once you get the hang of it, it can help limit any potential loss.

Keeping your level of cash on hand high can also allow you to move quickly to buy quality companies that are unfairly hit in any kneejerk reaction to non-company-specific events.

Ultimately, any dip or shakeout in the market would be healthy, and normalization of Fed policy away from emergency levels would be long overdue. Any correction would be a buying opportunity, if you're picking the right stocks. UBS pointed out that after an initial correction, the S&P 500 has gone on to rally 33% on average over the next two years.

Best wishes,

Mandeep Rai

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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