Welcome to the 2nd installation of the Wake Forest Review’s finance column: Cam’s Corner. This column will be a place where I offer anything from general thoughts on financial markets and economic trends to individual stock picks. It is designed to be a useful source of ideas for young adults beginning to invest for the first time and seasoned investors alike.
I will write this column on a weekly basis to be released on Monday mornings, so readers will be prepared before markets open each week. Furthermore, I would like readers to engage with me in the comment section by offering anything from opposing viewpoints to reaffirming ideas. This subsequent discussion will only improve the quality and usefulness of this column.
Week in Review
U.S. equities suffered heavy losses last week with the Dow Jones, S&P 500, and NASDAQ falling 4.12%, 3.85%, and 3.53% since closing at record highs on Friday, January 26th. In fact, the Dow Jones fell 2.54% on Friday alone, marking its largest single-day decline since the U.K. voted to leave the European Union in June 2016. Despite strong corporate earnings and continued economic growth, fears over inflation and interest rate increases largely fueled the sell-off. Let’s examine a few developing narratives that affected U.S. stocks last week and will continue to shape financial markets:
Wednesday’s Fed Meeting
Fed officials voted Wednesday to leave short-term interest rates steady. However, the Fed also did little to signal a change to its projected policy path, which would raise rates at the March 21st meeting and twice more in 2018. Investors speculated whether the Fed would raise rates two or three times this year, but it now appears that three rate hikes are far more likely. An increased probability of three rate hikes hurt U.S. stocks last week and may continue to do so. Higher interest rates typically prompt an economic cooldown as the cost of borrowing/spending for both households and corporations is increased.
Friday’s Jobs Report
The Labor Department’s jobs report on Friday may have altered the Fed’s projected policy path as well. Average hourly earnings for private-sector workers rose 2.9% in January from a year earlier, which is the largest year-over-year increase since June 2009. (Also, one-time bonuses that many corporations announced following the corporate tax cuts aren’t included in average hourly earnings.) Wage increases of this magnitude represent a tightening labor market and have spurred fears that the economy is overheating and inflation is overdue. Many investors are now surely projecting three if not four rate hikes in 2018.
U.S. 10 Year Treasury Note
Fears over wage growth and subsequent inflation also pushed the yield on the U.S. 10 Year Treasury Note up 18.2 basis points to 2.841% last week. U.S. equities have soared the past few years in part due to investors, faced with low yields on government debt, desperately searching for yield. However, now rising yields on government debt could help satisfy investors’ search for yield and diminish demand for riskier assets like stocks. Reporter Chelsey Dulaney said in an article in The Wall Street Journal that “Credit Suisse analysts are forecasting that U.S. stocks will begin to face pressure when the 10-year yield reaches 3.5%.” Look for inflationary pressures like wages to continue pushing the U.S. 10 Yr higher, which may cause investors to sell U.S. equities and buy treasuries.
If you believe U.S. equities will continue to climb higher from a weakened dollar, deregulation, corporate tax cuts, and strong economic growth, it may be a good idea to buy in this dip. However, you may want to consider these bearish investing options if you think inflationary risks, interest rate hikes, and changing investor sentiment will trigger a continued sell-off of U.S. equities. Note that these investing strategies represent difficult and risky attempts to time the market.
Bear Market Mutual Funds
Bear market mutual funds are generally not intended to be buy-and-hold positions, as stocks tend to go up more often than down. Furthermore, you will likely only make money if you buy at the right time. The bear market mutual fund I recommend is the PIMCO StocksPLUS Short Fund Class D (PSSDX). The fund has a gross expense ratio of 1.07% (category average is 1.92%) and total assets of $2.1 billion. PSSDX has averaged an annual return of -12.60% the last five years, while the category average and S&P 500 have returned -23.42% and 15.16%. PSSDX’s net asset value also increased 2.2% Friday as the S&P 500 decreased 2.12%.
Derivatives are complicated financial securities, and beginners should be cautious when dealing with them. Most online brokerages allow individual investors access to options trading if they can exhibit proficient understanding. Buying a put option on the Vanguard S&P 500 ETF (VOO), for instance, would be a reasonable method of betting against U.S. stocks. It would also be a good way to hedge risk if you still long U.S. equities but are growing increasingly concerned about one or more of the narratives previously mentioned.
Below is a profit chart representing such a hypothetical protective put. This scenario includes buying a put with an ask of 0.70, premium of $70, maturity of 40 days, and strike price of $220. It also assumes 100 shares of VOO were previously bought at $240. (VOO closed Friday at $253.19.) Put options give the buyer the right, but not the obligation, to sell at the strike price. Investors would obviously eat the $70 premium if the put remained out-of-the-money but would have unlimited profit potential and downside protection if the S&P 500 crashed before the option’s maturity. This exercise can be replicated similarly with different underlying securities, strike prices, and maturities.
ETNs that provide access to equity market volatility through CBOE Volatility Index (VIX) futures offer another method of hedging against market risk, as volatility generally rises substantially with market corrections. The iPath S&P 500 VIX Short-Term futures ETN (VXX), for example, increased by 13.48% Friday when the S&P 500 declined by 2.12%. Although there are numerous VIX ETNs, I like VXX’s gross expense ratio of 0.89% and total assets of $939.6 million. Much like bear market mutual funds, VIX ETNs shouldn’t be held for an extended period of time and represent perhaps ambitious attempts to time the market.