Down 19%, is it safe to invest in the stock market now?
As measured by Vanguard Total Stock Market Index ETF, the US stock market is currently about 19.4% below its recent highs. It’s still in the vicinity of a bear market, and there are plenty of reasons to remain nervous. In particular, with the Federal Reserve having made it clear that it will not stop raising interest rates until inflation is brought under control, the downward pressure on equities could very well continue.
This raises a key question: is it safe to invest in the stock market right now? Well, the direct answer to this question is Nope. Of course it is never safe to invest in the stock market. Your money is always at risk in the market. As a result, a better question to ask is whether the market drop has opened up opportunities where the potential rewards are worth the risks you are taking. With that in mind, there may well be a path that it might be wise to consider investing again.
Look where the fear is palpable
In a rising rate environment, some of the hardest hit industries are those that rely heavily on customers who need to borrow money to make purchases. For example, the S&P Home Builders Index is down much worse than the market as a whole, as people worry that rising rates and a tougher economy will keep people from buying new homes.
While it’s absolutely true that rising rates are making it harder to buy a home, it’s also true that building permits for new homes remain slightly stronger than they were at this time of year. last. As home building and home buying slows, we are also exiting what had been amazing housing boomand one where demand far exceeded supply.
There’s a big gap between a huge boom and a complete bust, and contrary to popular belief, people are still buying homes. It’s just not as fast a pace as during the height of the low-interest-fueled housing mania. The question you should really ask yourself is whether the palpable market fear surrounding homebuilders has made at least some of them available at a bargain price.
Similarly, rising interest rates mean that companies that deal with ready money have the opportunity to earn more on their loans. For example, even if consumers cost to borrow increased, the interest rates paid by banks on savings remain stubbornly low. Even so-called “high-yield” savings accounts are yielding just over 2%, even as 30-year mortgage rates have climbed to around 5.66%.
One of the main ways banks make their money is through the spread between the rate they pay depositors and the rate they lend to borrowers. The higher the interest rates, the greater the potential margin for this spread, which could ultimately translate into higher incomes for them.
Of course, the risk is that if too many people default on their loans, banks won’t be able to collect enough of their loans to fully cover their costs. If the economy remains soft and job losses start to mount, this risk may increase. While bank stocks are down, at least some worry is justified by the potential for things to go from bad to worse.
Are the risks and potential rewards balanced?
Neither homebuilders nor banks are risk-free investments, but both have generally seen their stock prices fall as the market has begun to recognize the risks both industries face. Therefore, investors buying today actually have a better potential reward profile for the risks they take than those who bought earlier when prices are higher.
Has the balance tipped far enough in favor of investors where they might be worth buying? It’s a little harder to answer, but you can usually get into the ballpark. A great approach to doing this is to use the discounted cash flow model to help you value the stocks you’re considering buying. With this model, you can get a good idea of both how much money you expect from a business and what that money is worth to you.
If the stock price seems cheap relative to the value suggested by the company’s cash-generating capabilities, the risk-reward balance may very well be in your favor. Even better, since you’ve built a model based on projections of cash the business is expected to generate in the future, you can use this model to check how the business is changing over time. This can help you keep an eye on the stocks you buy to see if their companies are really worth keeping.
Although bear markets often present opportunities to buy big companies at bargain prices, the market panic is unlikely to last forever. Make today the day you start looking for bargains. Once you’ve found and bought them, have the patience to let the market work through the rest of its worries. Do it successfully, and you may find that while it’s not safe to invest in the stock market now, it may very well turn out to be profitable.
Chuck Saletta has no position in the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Total Stock Market ETF. The Motley Fool has a disclosure policy.