American and Canadian stock markets face some risks. We advise you to continue to gradually invest in high-quality stocks, but if you’re fearful about a stock market setback, then conserve cash to take advantage of it. Even so, keep your existing investments.
The stock market faces risks. It always does. That’s why the market is said to ‘climb a wall of worry’ and why we always advise you to invest gradually. This gives you the benefit of ‘dollar-cost averaging’. That is, regular fixed investments buy more shares when prices are lower and fewer shares when prices are higher. This means that you buy most of your shares at below-average prices.
If you’re worried about a stock-market setback, you could also accumulate cash—particularly in RRSPs (Registered Retirement Savings Plans) and TFSAs (Tax-Free Savings Accounts). You could keep dividends and interest payments as well as maturing fixed-income investments in cash. Then, if the market does plunge, you can buy high-quality stocks at attractive prices. Just remember to keep your existing investments and limit your holdings of unproductive cash.
Trump policies could exacerbate already rising inflation
In January, the U.S. central bank calculated inflation at 1.9 per cent. This is close to its target rate of two per cent. President Donald Trump’s economic policies could push inflation above the threshold for several reasons.
First, labour costs will increase. That’s because companies will face pressure to transfer labour-intensive jobs from Mexico to the U.S. With American workers costing a lot more than Mexican workers, labour costs will automatically rise. In addition, with the U.S. approaching full-employment, employers who need workers will likely have to outbid other employers. This would raise salaries.
Second, high duties on imports to the U.S. are likely to disrupt supply chains. This will raise the costs of inputs made outside the U.S. It will take time to establish new supply chains. Many American consumers are likely to eventually experience ‘sticker shock’. The prices of many of the manufactured products that they need will become increasingly expensive.
The stock market faces some risks
The U.S. central bank recently raised its benchmark interest rate to one per cent and is expected to raise interest rates a couple of more times in 2017 to keep inflation at no more than its two per cent target.
Even with this interest rate increase, the ‘real’ or inflation-adjusted rate is still unusually low. In January, underlying inflation hit 1.9 per cent. This means that real interest rates in the U.S. remain negative.
The U.S. has plenty of company in the negative interest rate camp. The Economist magazine writes: “As measured by inflation-linked bonds, [real interest rates] are around -1% in big rich economies.”
Elroy Dimson of Cambridge University as well as Paul Marsh and Mike Staunton of the London Business School have carried out research. They find that very low real interest rates are associated with poor stock returns. This holds in the 21 countries they examine. The lower the real interest rate, the lower the stock returns in the following five years. But, with interest rates rising, equity returns could improve.
Another risk is that the bull (rising) market is getting old. As we wrote in our last issue, this is the second-longest bull market since World War II. At some point, a bear (falling) market will replace it. No one knows for sure just when this will happen.
Third, price-to-earnings ratios are high. Robert Shiller of Yale University created the Cyclically-Adjusted Price-Earnings, or CAPE, ratio. The earnings are the average earnings over the latest 10 years. The CAPE ratio is just under 30 times. The only times the ratio was higher was before the crash of 1929 and during the dot-com bubble of the late 1990s that preceded the ‘tech wreck’. This is hardly reassuring.
Positive factors include an upswing in the global economy—especially China and the European Union. This could increase company earnings and sales. That, in turn, is positive for stock prices.
Overall, we advise you to continue to gradually invest in high-quality stocks. If you’re worried, save up cash to take advantage of an eventual stock market setback.
This is an edited version of an article that was originally published for subscribers in the March 31, 2017, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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