How To Prepare For A Market Correction

July 10, 2014

A market correction is more a question of ‘when,’ not ‘if’; being prepared is crucial.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Anthony Parish, vice president of Research & Portfolio Strategy at Austin, Texas-based Sage Advisory Services.

As U.S. stock markets push their way to record highs, and corporate bond spreads approach record lows, nervous investors fret over a possible correction.

Are we due for a reversal of the five-year bull-market trend that stock and corporate-bond investors have enjoyed?

Our analysis of key corporate risk levels suggests there may be some more room to run, though we should probably be getting ready to get defensive.


Stock markets and credit spreads typically move like opposite sides of a seesaw, with one going up when the other is going down. In the uncertain world of the capital markets, this relationship is very reliable. Credit spreads fall as stock markets climb, and vice versa.

As the following chart shows, the spread of the Barclays US Credit Index has recently fallen below 1 percent. In plain terms, that means investors are willing to receive less than 1 percent of yield above the yield of comparable-duration U.S. Treasurys.


Source: Barclays Capital, as of 6/30/2014

One percent is substantially lower than one standard deviation below the mean credit spread since 2010. Understandably, credit spreads this tight tend to make bond investors nervous. If spreads reverted to their long-term mean over a short period of time, investors in popular ETFs that focus on this market segment could possibly experience significant declines.

Bond ETFs vulnerable to such a drawdown include:

However, others may look at this chart and see a different picture.

They might say:

  1. Based on a historical perspective, spreads still have room to tighten further before they reach record-low levels.
  2. Spreads can stay tight for several years, as evidenced by 2004 to 2007; therefore, investors should be wary of getting too defensive too early.

So which perspective is correct? Are we due for a correction, or can the risk markets continue their performance trends?


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