Cracks in the Euphoria: A Market Downturn is Coming

Market gains this year have been led by a small handful of high-profile stocks.  These high fliers include the infamous “FANG” names–Facebook, Amazon, Netflix and Google.  If those names start to show weakness, there isn’t enough momentum in the rest of the market to prevent a decline in the index valuations.  To make matters worse, trade tensions have given traders a reason for pause. Simultaneously, analysts have launched an attack on the safety trade, with Clorox getting downgraded.   Bond market analysts have indicated a potential “breakout” in interest rates, which causes fears that rates will move back toward the market moving 3% mark.

The EU is putting together a list of retaliatory tariffs, and those close to the president are tossing out phrases like ‘we are at war with China” and “zero sum game.”   Without speaking to the politics of it all, it is easy to surmise that when you go to war with your biggest trading partners, markets can’t perform well. These fears will likely keep the pressure on the industrials as well as the technology sector.  If trade fears and valuation concerns cause sufficient concern to investors, they may well take profits in a big way. Some analysts have pointed out that the “rolling bear market” of this year has not impacted technology and consumer discretionary stocks as of yet, and that their time is coming.

My advice is to watch the FANG names over the coming weeks.  Amazon actually lost value after reporting the best prime day ever, and when stocks sell off on good news, it is an ominous sign.

As I have argued in previous posts, investors that can’t afford to wait out a downturn should start moving their portfolio toward a highly defensive strategy.  There will no doubt be some up days where this strategy seems foolish, but given recent volatility, there will likely be more down days where this strategy provides a safety net.  Those stocks with the best returns over the past few years–those that have the highest beta–are the most likely to fall in a big way when there is a market downturn.   I like the low beta sectors like consumer staples.  Utilities and REITs have had some pretty big runs already, but they can often decline less dramatically even so because many investors believe that handsome dividends and less extended margins mean safety.   There may also be some measure of safety offshore, such as with Japan.

If you feel that bad times are coming fast, consider hedging your portfolio with an inverse index fund.  Inverse funds do the exact opposite of what the index does, so if you own one of these funds and the market tanks, you will do very well.   These funds keep managers very busy, and management fees are high compared to indexing strategies. In addition, they are not suitable for long term investments because, over time, markets will rise and you will lose money.  Think of these as trip insurance, not a whole life policy.

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