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.

Seesaw

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.

Barclays_Yield_Spread_JPEG

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?

 

Leverage Risk

To arrive at an answer, let’s take the temperature of corporate-risk levels.

In the early and middle stages of market cycles, corporations provide value for their shareholders by eliminating inventory overhang, optimizing operations and improving efficiencies. By contrast, in late-cycle rallies, corporations typically lever up their balance sheets to accommodate more speculative strategies such as expanding current businesses, entering new businesses and increasing mergers and acquisitions (M&A).

The chart below shows two key leverage levels among corporate stock and bond issuers: debt-to-earnings and debt-to-assets.

Corporate_Leverage_JPEG

Source: Bloomberg, as of 6/30/2014

Although corporate leverage has increased since 2011, it has not yet reached excessive levels. If we consider leverage to be a proxy for the market cycle, this suggests the cycle is mature, but not yet complete.

Some critics may argue the financial crisis was caused by excessive leverage, and therefore we can’t use historical leverage levels as an accurate gauge. That’s precisely why we removed the financials sector from our analysis. By excluding the leverage of banks and other financial institutions, we can reduce the distortions we would otherwise see in the data leading up to the financial crisis.

Current levels are still far below the peaks reached in the previous three market cycles.

For our part, we continue to hold exposures to large-cap and midcap stocks through the following ETFs:

Additionally, we are investors in high-quality credit and short-term high-yield debt, including CRED and HYS, which I mentioned above. These allocations make sense to us as part of broadly diversified portfolios in the current environment.

Evacuation Plan: Leave Early

In broad terms, we’re concerned about a dynamic that has been developing since 2007.

While the amount of outstanding corporate debt has expanded by 36 percent to $9.6 trillion, and credit ETFs assets have ballooned, corporate debt inventories held by the primary dealers and daily secondary market turnover have both declined significantly.

If dealer inventories and trading volume have fallen during benign credit conditions, where will the bidders be if the credit markets panic?

Note, we’re not predicting a crisis in the credit markets. Rather, we recommend investors take advantage of the current benign environment to plan out how they will respond when the market trends reverse. For more color on how Sage views this challenge, have a look at some of the previous pieces we’ve written on ETF.com addressing getting defensive in equities and diversifying fixed-income allocations.

A market correction is not an “if” but a “when” scenario. Just as surely as hemlines rise and fall in fashion trends, so too will the markets correct some day. The question is, Will you be ready?


Sage, an independent investment management firm, serves institutional and private clients with traditional fixed-income asset management and global tactical ETF strategies. Sage began using ETFs in 1998, and today offers a range of tactical all-ETF solutions, including income-focused and target-risk global allocation strategies. Contact Sage at 512-327-3330 or sageadvisory.com.


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