How to put your cash to work after this market dip

Until the end of January, investors seemed willing to shrug off any number of political and economic storms, everything from the threat of nuclear conflict with North Korea to a potential trade war with China.

On 2 February, however, sentiment turned and US stocks fell by more than 2%; it was the market’s worst week in two years. The catalyst was the US jobs report, which showed that average hourly earnings were nearly 3% higher in January than 12 months previously, which naturally prompted fears of higher inflation and proved a tipping point for growing concern that central banks might withdraw liquidity prematurely and kill off the recovery.

Interest rate risk

Interest rates have already been rising in anticipation of central bank rate increases later in 2018, and the yield on 10-year Treasuries is now approaching 3%, its highest level for four years. Critically, the two-year Treasury yield is rising above the S&P 500’s dividend yield, and the last time that happened was in the summer of 2008. Coincidentally, Janet Yellen stepped down as US Federal Reserve chair on 2 February, and the market cannot yet be sure that her successor Jerome Powell is similarly more committed to keeping interest rates low than containing inflation.

At any rate, the CBOE Volatility Index (the VIX), the closely watched gauge of investor anxiety, had spiked above 50 by the following Tuesday, its highest level since September 2015 and a reversal from its recent low and seemingly sanguine levels.

The stockmarket reversal is curious in that it comes at a time when several previously bearish investment bankers and analysts have changed their tunes, asserting that markets will continue to rally through 2018. They point to the sheer weight of money waiting to be allocated to markets, and to better than-expected earnings so far this year.

While last year’s soaring markets and breath taking valuations prompted comparisons with the late 1990s and 2007, increasingly the current cycle has been compared with the swinging 60s and even 1951, when post-war measures such as the Marshall Plan and the GI Bill successfully fuelled economic revival.

Indeed, the reversal is odd, and investor sentiment can be cantankerous. As long as the US economy keeps expanding at its current annual rate of 2.6%, a bit of inflation is almost immaterial. Corporate earnings – the key measure to watch – have grown nicely; and Trump’s corporate tax cut, to 21% from 35%, could add a further 8% boost to S&P 500 earnings in 2018 and take the full-year forecast to almost 18% more than 2017, according to Credit Suisse.

Trouble reading Trump

These reversals could be no more than a little froth coming off average US stock valuations of some 18 times forward earnings. Unquestionably, however, the market has trouble reading Donald Trump. The administration’s weak-dollar policy is contentious, for example – notably US Treasury secretary Steven Mnuchin’s rhetoric that a softer greenback “is good” for the country.

In fact, over the past decade, a falling dollar has been better for stocks than a rising dollar. Jodie Gunzberg, head of US equities at S&P Dow Jones Indices, who has crunched the data, says that on average for every 1% the dollar falls, stocks rise by just under 3%.

Similarly, although Trump signalled at Davos that he might reconsider his line on the Trans-Pacific Partnership trade agreement, the US Trade Representative’s investigations into Chinese theft of US intellectual property could start a trade war.

The US has already imposed tariffs on solar panels and washing machines, which fortunately have had little impact because manufacturing costs have fallen fast. But if Trump’s administration files new complaints with the World Trade Organization, or imposes steep tariffs on Chinese imports, Beijing will respond in kind, and at a time when US conflict with Mexico and Canada is also growing.

Then there is the prospect of a damaging interview with Robert Mueller, the special prosecutor tasked with investigating whether there was collusion between Trump’s presidential campaign team and Russia. The president is prone to off -the-cuff remarks and exaggerations, and Muller will have at his fingertips all Trump’s previous pronouncements and contradictory comments on his business dealings, so he is very likely to trip Trump up.

Investors will no doubt buy the dips in the weeks ahead, but the best opportunities will be in faster-growing US smaller companies, which are less affected by the international picture. Jodie Gunzberg’s back-data suggests that on average for every 1% of GDP growth, the small-cap S&P 600 index has historically gained 5.1%, while the large-cap S&P 500 has risen by 4%. We are going to take a leap of faith and invest some of our cash pile into the iShares S&P Small Cap 600 UCITS ETF.

Recent events underline the importance of not trying to time the market, advice which is very much easier to give than to follow. In uncertain times, it can be better to trust in dividends, as a reliable income stream goes a long way towards alleviating the pain of falling capital values. In the UK this niche is dominated by a few big stocks in a small number of sectors such as oil and banking, so it is better to spread the net more widely to include smaller stocks, preference shares and other forms of income.

This month we must report that one of the portfolio’s holdings, the iShares US Pharmaceuticals ETF (IHE), took a particular battering following the exciting news that Amazon (AMZN), Berkshire Hathaway (BRK.B) and JPMorgan (JPM) are forming a not-for-profit company to look after the healthcare of their hundreds of thousands of US employees.

It’s Amazon’s participation that has fuelled panic in the pharmaceuticals sector, given the way it has transformed the retail industry. But while a press release mentions that the venture could benefit all Americans by disrupting the overpriced drugs market, details are sketchy, and it will be years before the project meaningfully affects the US pharmaceutical industry.

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation, and is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.