Share market vulnerable as 2024 gains wiped out this month

A 291-point or 3.69 percent dive in the benchmark ASX 200 index over April has all but wiped out the Australian share market’s gains for 2024. There was a 140-point or 1.81 percent drop in the ASX 200 on Monday and a minor further fall yesterday. The Australian market has followed the US lead this month, with the S&P 500 also down significantly, losing 232 points or 4.42 percent since 1 April.

The catalysts include last week’s hotter-than-expected US inflation data. Although analysts think Australian inflation is unlikely to follow suit, stickier-than-expected inflation in the US may delay the first interest rate cut by the US Federal Reserve. As the US is the world’s largest economy, this may have implications for central bank decisions in other nations like Australia.

“ … uncertainty over when the Fed will start to cut rates has been increased by three worse than expected monthly CPI inflation results in a row …,” said AMP chief economist Dr Shane Oliver. “This has seen money market expectations for 0.25 percent rate cuts this year scaled back from seven starting in March this year to now less than two starting in September. And in Australia they have been scaled back from nearly three starting in June to no rate cut until late this year/early next.”

On top of that, Iran’s retaliatory strike on Israel and Israel’s insistence that a response will be forthcoming despite many Western nations’ objections have made investors nervous. If Iran were to become more involved in the ongoing war, this may have ramifications for oil prices.

“Another sharp spike in oil prices would be a threat to the economic outlook as it could boost inflation again … potentially resulting in higher than otherwise interest rates and act as a tax hike on consumers leaving less to spend on other things,” Dr Oliver said.

Also, in Australia, the pandemic savings buffers people have been using to cope with the cost of living crisis are being depleted and China’s weak property sector is impacting demand for iron ore. All of this makes shares vulnerable to a pullback amid stretched valuations and more trading volatility ahead, Dr Oliver said.

On balance though, Dr Oliver thinks an upward trend is likely to remain for shares. “From their lows last October, it has been relatively smooth sailing for shares – with US shares up 28 percent, global shares up 25 percent and Australian shares up 17 percent to recent highs.”Dr Oliver said the past few weeks have “seen a rough patch” but the share market is likely to continue its bull run.

Markets have been strong since November 2023 due to falling inflation and optimism that the interest rate cycle is at its peak. Many economists have expressed surprise that the jobs market in many Western countries has remained strong despite weaker economic conditions. Some are terming this “immaculate disinflation” because it goes against the traditional trend of many people losing jobs when economies slow down.

Dr Oliver says there are five reasons to be optimistic about the share market’s strength:

1. Technical market indicators, including churning and a decline in the proportion of stocks reaching new price highs – common at the top of markets – are not in play

2. Global and Australian economic conditions and company profits are holding up better than expected

3. Inflation has fallen sharply in many major economies, so while rate cuts may be delayed, they are still likely

4. China still expects about 5 percent economic growth this year despite its property slump. The iron ore price has fallen but remains in the same range of the past two–and–a–half years

5. Geopolitical risks remain high but an escalation may not eventuate, just like last year.

In this climate, Dr Oliver recommends that investors stick to an appropriate long-term investment strategy and accept that share market pullbacks are “healthy and normal”.

The past five years have been good to stock-market investors. The S&P 500 index has climbed an annualised 12% during that period, outstripping the 9% annualised gain over the past 40 years. This year alone the index is up 6.9% as of April 26, tacking on to the 24% gain in 2023.

But signs are emerging that the stock market could be due for a breather. As of April 25, the S&P 500 went 133 trading days without a decline of at least 10%, according to PNC Institutional Asset Management. To be sure, that’s still short of the 172-day average since 1928. But the S&P 500 has jumped 24% in the past six months (about 180 days), which buttresses arguments for a correction.

What’s more, the multiyear ascent has arguably sent stocks to overvalued levels. The S&P 500’s forward price-to-earnings ratio—a gauge of market valuation based on earnings estimates for the next 12 months—registered 20 as of April 26, exceeding the five-year average of 19.1 and the 10-year average of 17.8, according to FactSet.

“A correction is certainly possible,” says Jack Ablin , chief investment officer at wealth-management firm Cresset Capital, pointing to the high valuations and the prospect that rate cuts will come later than expected thanks to inflation that has been higher than expected.

Given the danger of a stock-market correction, commonly defined as a 10% to 20% drop, how can investors guard the profits they have made in recent years?

Wait and see

Assuming you have a well-diversified portfolio and aren’t counting on the money from your stocks to finance an imminent expense, financial advisers say the best strategy is to hang tight.

Corrections generally don’t stick around long. Since 1985, declines between 10% and 20% for the S&P 500 have lasted only 97 days on average—three-plus months—according to a CFRA analysis of S&P data.

It then has taken the market an additional 101 days on average to recover the ground lost during the correction. So in about six months, investors tend to be back where they were before the correction.

“If there’s a shallow correction of 5% to 10%, we recommend riding it out,” says Karim Ahamed , an investment adviser at wealth-management firm Cerity Partners. “Eventually the market recovers. The idea of selling out and climbing back in is difficult to achieve. You’re more likely to stay on the sidelines with your losses crystallising.”

The S&P 500 did fall more than 5% in recent weeks, from March 28 to April 19.

Sell losers

Some people, though, simply find it impossible to do nothing if they fear a correction is looming. At the least, they want to protect the gains they have earned so far. What’s the most prudent way for them to reduce their market exposure?

Keep in mind that most actions you can take to guard your stock profits carry a cost. The easiest method, selling stocks, subjects you to capital-gains taxes unless you are selling from a tax-advantaged retirement account. That tax rate varies according to your income, but will likely be 15%.

One way to limit the burden is through tax-loss harvesting, says Amanda Agati , chief investment officer of PNC’s asset-management group. That is when you sell stocks at a loss, lowering your net capital gain. If you have any dogs in your portfolio—stocks with poor fundamentals—you can unload those.

If you do sell stocks, you could put the proceeds into a money-market fund for now, financial pros say. Many such funds yield 5% or more, far higher than rates over the past 15 years. Or if you want to increase the safety of your overall portfolio, you could put the money into safe government bonds. Three-year Treasury notes yield around 4.75%.

Play defence

If you are going to unload stocks, but don’t want to sell right away, you can put in a stop-limit sell order through your brokerage. That order can automatically sell your shares if they slide to a level you designate (they can go below it, too), protecting you from big drops.

Say you bought 100 shares of Tesla at $140, and they are now trading at $165. If you don’t want your profit to disappear in a downturn, you could enter a stop-limit sell order with your brokerage at $150 for some or all of your shares. Those shares can be sold if the price reaches $150, securing some of the gains.

You also might shift your holdings more toward defensive stocks, such as utilities and consumer-staple companies, which generally outperform during market downturns, says Michael Sheldon , executive director of wealth-management firm RDM Financial Group.

PNC’s Agati suggests an emphasis on quality stocks, those with high recurring revenues, strong and dependable profit margins, high cash flow and low debt. These stocks—such as AutoZone and Visa , she says—have lagged behind the leaders of the market’s surge over the past year.

Consider options

Advisers also suggest looking at “put” options to protect your stock gains. Puts give you the right but not the obligation to sell a security at a preset price by a preset deadline.

Note that we’re talking about a risk-reduction approach here, not the kind of risk-taking—to try to amplify returns— that has been rampant in the options market . The simplest strategy could be to purchase a put option on a market-index exchange-traded fund, such as one based on the S&P 500. You could buy puts on individual stocks rather than an index ETF, but that may get expensive and complicated as each option carries a purchase premium.

Here’s how the ETF strategy would work: First, buy an option that would let you sell the ETF at a price below the current one, protecting you from declines beneath that level. You wouldn’t have to sell the ETF, and you wouldn’t even have to own it. As the S&P 500 falls, the put option gains in value, and you can sell it.

Say on April 16 you wanted to protect 100 shares of SPDR S&P 500 ETF Trust (SPY) from a decline of more than 10%. With the ETF trading at $505 a share, you could buy an option that covers 100 shares for $1,050, or $10.50 a share. You’re paying a premium equal to 2% of your position.

The option’s expiration date is December, and its strike price is $455 a share, or 10% below the current value. The strike price is the price at which you could exercise the option. But generally you sell the option rather than exercising it, so you don’t have to dump any shares, especially if you don’t own them.

If the market doesn’t go down 10% by December, you let the option expire worthless, and you’re out the $1,050 you paid for it. If the market drops more than 10%, you can sell your option at a profit whenever you want until December.

While it might be more lucrative to sell it early, Ablin recommends holding until expiration if you’re using the option to protect your portfolio. “Think of it like homeowner insurance,” he says. “You pay a premium, like a deductible for insurance, and your coverage runs for a term.”

Keeping the option until expiration extends your coverage for the longest possible period.

By using options, you don’t have to sell any of your stocks, which are typically the best asset to generate strong long-term returns. “If you have the wherewithal to hold the S&P 500 for 10 years, your odds of making money are over 90%,” Ablin says.