Why the Odds Favour a Market Correction

Let’s kick off the week by scratching the surface over the bungled missile alert that went off in Hawaii yesterday.

In case you weren’t aware, Hawaiians received a text message alert at 8am on Sunday morning, warning them of an incoming ballistic missile…and that it was not a drill.

It took nearly 40 minutes before anyone was told that it was all a big mistake. The official story is that ‘an employee pushed the wrong button’.

Really? Does anyone really believe that?

Who was the ‘employee’? Why did a mere ‘employee’ have access to a vital (and what should have been a secure) communication system?

It doesn’t pass the sniff test at all.

It was no accident. If it was, why did it take nearly 40 mins to rectify it? Why wasn’t someone with an ounce of authority on the phone asking what the hell was going on?

Because it wasn’t an accident. It was an attempt to see what the public’s response would be in the event that North Korea launches a missile at Hawaii. That’s my guess, anyway. Because it’s much more plausible than the rubbish issued to the news outlets.

But the mainstream media did their job and duly reported the official cover up. That is, some unnamed employee pushed a button without ANYONE authorising it!

Oh, the hilarity…

Anyway, now I’ve got that off my chest, let’s get on with it…

Let’s talk about the government bond market for a minute. Yields spiked this week and everyone freaked out. I mean…the biggest bubble in the world is the process of blowing up!

Except that’s not really true. For a little perspective, have a look at the following chart. It shows the US 10-year Treasury bond yield.

As you can see, yields were around the same level in December 2016 and March 2017. Sure, the trend is towards rising yields…as it should be in a strengthening global economy, moving from a disinflationary to an inflationary environment.

10_year Treasury Note Yield - TNX (WI) - Daily Chart | 15-01-2018

Source: Optuma
[Click to enlarge]

But betting on a bond bubble bust is a tough trade. That’s because yield movements are glacial. For example, after hitting 2.6% in March last year, yields then fell back to nearly 2% in September, before heading higher again. 

If you’re a stock market investor though, you do need to be wary of interest rate sensitive sectors like infrastructure funds and property trusts. These are the sectors that usually sell off when bond yields start to rise around the world.

And sure enough, infrastructure plays like Transurban [ASX:TCL] and Sydney Airports [ASX:SYD] are all down in recent weeks. As are property trusts across the board.

That’s because the market sees them as having ‘bond-like characteristics’, and prices them based on their dividend yield. So when bond yields rise, the dividend yields of these companies rise too, which means the share price must fall.

Still, none of this is bothering the overall stock market. Bond yields are rising because of strong global economic growth and the prospect of inflation, which is good for stocks.

Let me be clear on that point. Inflation is good for stocks. It’s only when inflation gets out of control, say above 4–5% like it did in the 1970s, that the stock market will react negatively.

That’s still a long way off. In fact, there is no guarantee that inflation will pick up from here. It’s still below 2% in most of the developed economies. Huge debt burdens are deflationary, not inflationary.

In other words, if a strong pick-up in inflation is coming, it might take some time. Still, that hasn’t stopped the market latching on to anything that could be bullish for stocks.

Tax cuts, rising inflation, a weaker US dollar, strong economic growth…these are all reasons for the markets’ strong rally right now.

While you’d have to think nearly all of these positives are priced in, the market just keeps marching higher. Check out the chart of the S&P 500 since the bull market began in 2009.

Prices have recently gone vertical. That’s not sustainable. I’d therefore expect a decent correction to unfold in the next few months.

S&P 500 Index - SPX (WI) - Daily Chart | 15-01-2018

Source: Optuma
[Click to enlarge]

But what I expect and what will happen are two different things. The market always delivers the unexpected. Prediction is futile, because the market will always make a fool out of your predictions.

The best option is to think about probabilities. What is the probability of stocks going higher here, versus the probability of a correction playing out?

The odds favour a correction. So be patient, focus on out of favour stocks that haven’t enjoyed the rally, and take some money off the table if you’ve enjoyed some big gains.

Greg Canavan,
Editor, Crisis & Opportunity

Greg Canavan is a Feature Editor at Money Morning and Head of Research at Fat Tail Investment Research.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

Official websites and financial e-letters Greg writes for:

Money Morning Australia