Early Investing

How to Hedge Against Stock Market Turmoil

How to Hedge Against Stock Market Turmoil
By Adam Sharp
Date December 7, 2018

Dear Early Investor,

After nine years of relatively smooth sailing, stock markets have hit rocky waters.

The market is not reacting well to the prospect of higher interest rates. The trade war mess certainly doesn’t help. But I believe the primary driver is the Federal Reserve.

The problem is, nobody knows what the Fed is going to do. If it keeps hiking interest rates, real estate and stocks will take a hit.

An old saying has it that the Fed’s low interest rate policy is like a party with a spiked punch bowl. Once it gets going (with all that easy credit), nobody wants the economic party to end.

According to the Fed’s philosophy, it should keep hiking. Its measures of the economy say we’re near full employment. And inflation is creeping up (a factor that’s very underreported). So the Fed is in a real pickle here, and I don’t envy its situation.

I continue to have serious doubts the Fed will follow through on normalizing rates. In some ways, it can’t keep hiking. To keep the debt-fueled recovery going, we need cheap money and high valuations on stocks to make people feel wealthy and spend more (the economic term is “wealth effect”).

If the Fed continues tightening, the market could crash. But if the Fed pushes rates back to zero, that will likely create inflation and more asset bubbles. Sure, stocks would go up. But the long-term effects could be very ugly.

In short, I think no matter what the Fed does, U.S. stock markets are poised for slower real growth for the next decade. So the question is, where do you park investment cash that had been earmarked for stocks?

Cheap Emerging Markets

Even after the recent market sell-off, U.S. stocks remain on the expensive side. I believe this is primarily due to the Fed’s artificially low interest rates. When you push down bond yields, stocks become more attractive because you get a similar yield and growth potential.

One way to hedge your exposure to this risk is by buying select international stocks. Markets in China, Russia, Turkey and Brazil are all trading at far cheaper valuations than the U.S. market is.

Russia’s main stock index trades at a price-to-earnings (P/E) ratio of around 5 and sports a more than 4% yield, for example. Chinese stocks also look attractive here, trading at an average P/E of 14 with stronger growth prospects (compared with a P/E of 21 on the S&P 500).

Naturally, you take different risks owning emerging market stocks. If their currency falls relative to the dollar, they decrease in value. But that’s the point. You’re diversifying away from domestic risk, which is more important than ever today.

Plus, you’re paying a more favorable price for the stock. And eventually, good things tend to happen to cheap stocks.

In a recent interview with CNBC, Vanguard Group CEO Tim Buckley, one of the most respected names in investment funds, made the case for international stocks this way:

When you start off with higher valuations, you are just going to get lower returns going forward… Markets have come down a bit… We were at frothy valuations to now simply high valuations.

Vanguard said it expects international stocks to outperform American ones by 3% to 3.5% per year over the next 10 years.

And with the dollar still very strong against emerging market currencies today, you get a lot of bang for your buck in “emerging” markets.

ETFs are the best way for most people to get exposure to these markets. There are now funds for nearly every country and region. Also, I am avoiding exposure to Europe and Japan. They are not emerging markets, and they are in a similar financial situation to that of the U.S.

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