Markets are ripe for a correction - prepare yourself for turbulence

published 22 October 2012

Friday was the 25th anniversary of Black Monday', the day in 1987 when major stock markets around the world collapsed in a single session.

As if in tribute, the US stock market saw its worst day since June, with the Dow Jones index falling by more than 200 points.

It was hardly a historic plunge. But it's a sign of just how jittery investors are right now.

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They're right to be. There could be a lot more disappointment ahead.

You don't need to search far and wide to see what rattled investors on Friday a series of US companies turned in disappointing results.

The technology sector has had a tough time this earnings season, with weak numbers from Google, Microsoft, chip-maker Intel, and IBM. But it's not just technology. Conglomerate GE and fast food giant McDonald's also came in below analysts' expectations.

For a defensive multinational like McDonald's to miss is particularly worrying. Sales growth around the world slowed in October. If consumers everywhere are having trouble affording a Big Mac, the outlook must be gloomy.

If the US market was cheap, this wouldn't be such a problem. There's a price for everything. Sometimes a market is priced too optimistically, sometimes too pessimistically.

If a company is priced to go bust, then things only need to get just a little but better for its share price can shoot up. But if a company is priced for perfection, then even the slightest disappointment can batter the price.

That's the problem in the US right now. Stocks have got caught up in a wave of excitement over a US economic recovery. But even if a big US recovery was a certainty (which it's not), there's another problem.

The rest of the world just isn't that healthy at the moment. And nearly 50% of revenues for S&P 500 companies come from overseas. So a slowdown in China and recession in Europe matters for US stocks. And it matter even more, given that they are already overvalued by historical terms.

This slowdown is global just look at the currency markets

If you need any more evidence that the slowdown is going global, you need only look to the currency markets. An interesting piece on Bloomberg this morning notes that the once very profitable 'carry trade' has lost its charms.

In the currency markets, a carry trade is quite simple. You borrow money in a low-interest rate currency (such as the US dollar). You then buy a high-interest rate currency (like the Brazilian real) with the proceeds.

In the good old days, this paid off brilliantly: you profited from the gap in interest rates; and made capital gains too. Everyone wanted to own growth' currencies, so as the Brazilian real continued to gain against the dollar, you'd make a nice return.

The trouble with carry trades, of course, is that you are playing with borrowed money. And when those sorts of trades go against you, it can be ruinous. The risk in this case is that the US dollar (which you've borrowed in) starts rising against the Brazilian currency. So you end up owing more than you originally borrowed.

This is why the carry trade has often been described as "picking up nickels in front of a steamroller." But it didn't put anyone off while it was profitable.

Trouble is, that's changed. Carry trades have been losing money this year. And foreign currency traders have become much more cautious last month, average daily volume traded in the currency markets fell by 39% year-on-year, according to data from ICAP, says Bloomberg.

What's spooked currency traders? The trouble is, the fast-growing economies are no longer growing rapidly. Their central banks now look more likely to cut interest rates than to raise them. Falling interest rates usually weaken a currency.

Meanwhile, the low-growth Western economies aren't getting any better. They certainly won't be raising interest rates any time soon. But they don't have any scope to cut interest rates further. And no one is entirely sure of what quantitative easing actually does. Does it help the economy or is it counter-productive?

In short, the hot' economies of the world are slowing down, and the low-growth economies don't look like picking up the slack. So no one wants to place big bets on any one country outperforming the others.

What does this mean for you?

As we discussed on Friday, investors have become rather complacent. There are all manner of things that could derail the fragile sense of recovery: from a hard (-er) landing for China to another panic in Europe to political deadlock in the US.

It pays to be cautious in this sort of environment. As we've already noted, we'd hang on to stocks in cheap markets, but we'd be very wary of the US. Also, despite signs that blue-chip stocks paying decent yields are getting rather too popular for our liking, we'd stick with them too and perhaps update your watch list', as you may get a chance to buy some of them cheaper in the weeks and months to come.

However, not every economy is grinding to a crashing halt. One region contains some potentially extremely interesting long-term opportunities Africa. My colleague Matthew Partridge will be looking at the good news stories coming out of the continent in this week's issue of MoneyWeek, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.