BUY, SELL, HOLD? YES!

For the past six years, the US stock markets have enjoyed a prolonged bull market. This historic run rose from the rubble of the 2008 financial crisis and, aided by near-zero interest rates and three rounds of quantitative easing from the US Federal Reserve (the Fed), pushed US stock indexes to record highs. During that same time, consumer sentiment rebounded and unemployment fell from double digits to a mere five percent. For investors looking to recover from the losses of 2008, this has been a godsend. Unfortunately, we are starting to see signs that this bull market is nearing its end.

When discussing the slowing US stock markets, the conversation starts with earnings. Investors watch earnings very carefully as an indicator of a stock’s fair price. In 2014, corporate earnings per share leveled off and they started to decline in 2015. This was not unexpected, since profit margins have been declining and revenue is not growing fast enough to prop up earnings. When compared to their earnings, US stocks are already much more expensive than their European peers and, if earnings stay stagnant in the US, then those European stocks will grow more and more attractive.

In its December meeting, the Fed finally raised interest rates. The hike is only a quarter point and should have a minimal effect on borrowing costs, but it sends a message that the US economy is healthy enough that we can start the journey back to “normal” interest rates. For consumers, that news is a mixed bag as borrowing costs for homes and cars will increase. However, “normal” interest will allow retirees to use safer investment vehicles to provide their income and will not need to rely so heavily on volatile assets, like stocks, to fund their retirement.

As interest rates stand now, high-quality bonds pay very little in interest. In fact, they pay little enough that investors need to look to alternative sources of income (e.g. junk bonds, real estate investment trusts, hybrids, etc.), and the resulting demand from investors allowed those alternative assets to hold their borrowing costs down. As interest rates start to rise, investors will gradually transition from higher risk alternatives to lower-risk bonds, which will drive up interest rates on those alternative assets. This process will take time, but it will ripple through the global bond market.

The junk bond market is already beginning to feel the effects of this process. Investors anticipate rising interest rates, so they are unwilling to purchase new low-quality bonds that do not offer higher interest rates. This is driving up the borrowing costs for borrowers offering junk bonds. Unfortunately for those borrowers, 2015 saw an increase in the number of junk bond defaults. Defaults make investors nervous and they require even higher interest rates to compensate them for that default risk. This combination of rising interest rates and an increased default rate resulted in a difficult year for junk bonds as investors trimmed their exposure to that asset class.

China halted trading on its stock exchange on the first trading day of 2016, due to a sharp fall in prices. During the volatile summer, Chinese officials instituted a number of emergency measures to control the declining Chinese market, and this mechanism to stop trading was one of those measures. The US exchanges use a similar system to prevent investors from panicking and to allow cooler heads to prevail. The Chinese market is struggling, but we expect that it will find its feet again eventually.