While the stock market is hitting its highest level since the end of 2018, there are plenty of signs that the economy may be running out of steam. Consumer spending is softening, despite massive tax cuts and higher wages. The inventory buildup that has been helping boost production growth may have peaked. And, according to a major annual survey, American households are cutting back sharply on purchases. Even if the economy bounces back, the outlook is for a slowdown that will test the resilience of the stock market.
That’s because the economy’s boom was fueled by gigantic distortions in financial markets, and to some extent, by inflation and debt that were not self-reinforcing. The stock market bubble and the housing bubble preceded the Great Recession by about a decade, while the bursting of the latter left a big dent in the economic activity of households and firms. The yield curve between the short-term and the long-term rate has been flattening, a worrying sign that this is the new normal. Longer-term rates are down more than shorter-term rates, but that difference has recently narrowed. In general, a flattening yield curve presages recessions. In its March report, the Federal Reserve suggested that longer-term rates and inflation have been mispricing the economy. So what can investors do to avoid a crash? Here are five rules of thumb: 1. Pick the right companies.
Profits remain a strong signal of corporate health. There are some companies out there that will do well no matter what happens in the economy. Visa, Southwest Airlines, 3M, Apple — and this is not the very last one — are companies whose profits are almost always pretty steady no matter what the rest of the economy does. Those include a lot of consumer-facing firms, but the highest-quality companies will always do well no matter what the rest of the economy does. Those types of companies should generally trade at a discount to the market. 2. Don’t sell stocks just because you’re not feeling good. If you think this market looks “good” and you don’t think the problems in China and other parts of the world have gotten better, you should buy stocks.
The economy is strong; profits are steady; valuations are low. It’s tempting to start cutting and running after a pullback, but if you wait around, you’ll miss your opportunity to make money. That should be your bottom line. 3. Cut up your credit cards and ditch the mortgages. Those two debts are the worst of all. Rising unemployment and slower wage growth means that many people will have to stretch further before they can meet their monthly payments. It’s a great time to make a move to lower-cost credit cards. And mortgage debt is an even more toxic investment — even with borrowing costs low, higher rates are going to make it much more difficult to pay off all that mortgage debt. 4. Don’t go into debt for new investments.
One big reason that stocks looked so attractive when the market was at all-time highs was that low interest rates meant that businesses would have trouble finding the cash they needed to invest in new machinery and facilities. This may all start to change soon. Fed Chairman Jerome Powell has made clear that the central bank is prepared to increase interest rates even faster than it did over the past year. More interest rate hikes mean that businesses can borrow much more easily and buy new equipment. That is bullish for stocks. 5. Don’t pay too much attention to the individual asset prices. Remember that stocks had to decline from their pre-crisis peak price for more than a decade before they could recover from the financial crisis.
While stock prices can do a lot of spectacular things, they are not correlated to every other business asset. Consider other asset prices, such as housing, copper, oil, and wheat — or, alternatively, consider trading rules: Don’t buy stocks based on expectations about that index, either. The stock market isn’t always a reliable guide to the economy, but nobody should do anything under the assumption that it is wrong all the time. If it does make the right call about the economy, in other words, there is an enormous amount of room for your portfolio to grow — and for your income to grow as well. So if you have cash lying around, maybe it’s time to use it.
