Rising interest rates, toothless FAANG stocks, domestic and international political uncertainty and tension, Brexit, crude oil – take your pick. The market’s got a lot on its mind right now.
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You can turn on any cable news channel and watch folks holding forth on these and a handful of other worries.
But what you won’t hear about is a heavy and potentially very dangerous factor out there creeping in around the edges.
I’m talking about correlation – and why it could quickly become a nightmare for unprepared investors…
This Is My Single Biggest Fear Today
Correlation is a simple phenomenon. It’s when different markets and different asset classes start acting the same and moving together.
At the height of a bull market, it can be a profitable thing; you get the feeling you could throw darts at a list of stocks and pick a winner.
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But it cuts both ways.
When correlation picks up in a bearish environment, different asset classes can start moving down together, and something very bad can happen.
We’re not in a bear market, at least not yet. But we could get there – and several asset classes could get there much faster than folks realize.
Now, clearly the stock market is in a dicey position, to start with.
All the leadership stocks, principally the FAANG stocks, that propelled markets higher for years, have all rolled over. Several of them are already in bear markets.
Remember: A correction is a 10% move down from a recent high or an all-time high. A stock enters a bear market when it falls 20%.
Here’s what you should be watching out for…
Danger Sign No. 1: the FAANG Stocks
Facebook Inc. (NASDAQ: FB) is in a textbook bear market. It’s been as low as 42% down from its 52-week high of $218.62 before rebounding slightly this week. However, it’s still off more than 38%.
Apple Inc. (NASDAQ: AAPL) slid into a bear market, down more than 25%.
So far, only Google’s parent company, Alphabet Inc. (NASDAQ: GOOGL), has kept its nose above water. But down more than 18.7% as it is, it’s looking awfully close.
More stocks have been making 52-week lows than 52-week highs for months now. In fact, fewer and fewer stocks are getting anywhere near making new highs. The momentum has completely changed for them.
Well, there are lots of reasons investors may be taking profits and pulling cash out of the stock market.
People are afraid that earnings and profit have been as good as they can get. There are fears that a nine-and-a-half-year-old bull market has run as far as it could – and worries that the business cycle can’t continue much longer.
In other words, psychology has changed.
One of the principal reasons psychology has changed is that the big, fundamental whip that’s driven stocks higher for years has finally stopped cracking. The U.S. Federal Reserve’s been raising interest rates; it’s a completely different picture than the quantitative easing phase where the market was awash in trillions of dollars in cheap-as-free money.
Which brings us to the next troubling indicator…
Danger Sign No. 2: the Credit Market
Bond prices have been falling – into bear market territory, I’d add. Bond prices fall as interest rates rise because investors (who are interested in buying new issues with better interest earning power) won’t pay the same price for old bonds that don’t yield as much.
So holders of those lower-yielding bonds, if they want to sell them, must lower the price they’ll take to some level where their old bonds are “yield competitive” with new bonds coming to market.
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The more interest rates rise, the more existing bond prices fall.
Now, that hasn’t happened in the Treasury market, for mechanical reasons, including the “flight to quality” we see when markets sell off. But virtually every other bond class under the sun – including corporate paper and junk – has been bleeding out for months.
Spreads have been widening on investment-grade bonds. That’s a sign that prices of investment-grade bonds are falling. Spreads refer to the difference, or spread, in yield between any kind of bond and its equivalent maturity Treasury bond, note, or bill.
The spread on junk bonds just reached a 19-month high last week.
In other words, bond prices are falling as stock prices are falling. That’s one big, huge correlation.
It doesn’t stop there…
Danger Sign No. 3: Crude Oil & Commodities
Investors who are long the black stuff are seeing red.
West Texas Intermediate (WTI) crude oil fell 7% in one day last week, knocking the per barrel price of WTI down to $55.69 from $70 only a month ago. Crude is now 32% down from its 52-week high of $76.90. Oil has now seen the longest slide without an uptick in its history.
Commodities in general have been slipping as stock prices have been falling. Higher interest rates hit commodity prices as carrying costs, planting costs, and harvesting and storage costs increase with higher rates. That’s more correlation.
Residential real estate prices may have peaked in some hot markets recently, and sales have slowed as mortgage rates have ticked higher. That’s more potential correlation.
Even gold has fallen over the past year, sliding from $1,350 down to $1,221. Correlation.
The problem with bearish correlation – different asset classes and moving down together – is that any steep sell-off in one triggers selling in others.
That can generate a nasty negative feedback loop, especially if margin calls in the stock market cause investors to sell other assets and selling those assets scares investors in those asset classes, who sell and can trigger margin loan calls elsewhere, and on and on.
You don’t have to do much imagining to see how ugly it can get in a hurry. Some of the most vicious, furious rounds of correlated selling-off I’ve ever seen happened in – you guessed it – autumn, 2008. We all remember what happened to stocks then.
Now, I’m not saying we’re anywhere near that point. But increasingly tighter correlation is becoming an increasingly big worry.
But at times like this it’s important – critical, even – to remember that the profit potential in a bear market can be just as big, if not bigger, than in a bull market.
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