Understanding Market Risks in the US Stock Market
As a US stock market explorer, I want to share my approach to analyzing market risks, particularly for individual investors. I believe that considering the type of risk involved is crucial for making informed investment decisions.
Three Types of Market Risks
I categorize market risks into three main types:
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Structural Risk: This is the most severe type of risk, characterized by long-term impact and widespread consequences. Examples include the 2008 financial crisis, the dot-com bubble of 2000, and the Great Depression of 1929. Structural risks are relatively infrequent but can be devastating.
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Cyclical Risk: This type of risk is more common in the US stock market, occurring roughly every three to five years. It is driven by natural economic cycles, such as periods of overheating followed by recessions induced by measures like interest rate hikes by the Federal Reserve. The market downturn of 2022 is a typical example. These events typically cause a 20-30% drop.
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Event-Driven Risk: These risks are triggered by specific events and tend to be short-lived. Examples include the Japanese yen carry trade situation from last year or the Deep Sea incident from earlier this year. The impact can vary, with price drops ranging from 5% to 15%, but recovery is usually swift.
Applying the Risk Framework to Tariff Concerns
When faced with a risk, I consider whether it is event-driven, cyclical, or structural. I applied this approach to analyze the risk associated with tariffs, breaking it down into two components:
- Policy Risk: This refers to the direct impact of the tariff policy itself, such as the specific percentage imposed or the potential for retaliatory measures. If policy is the only problem, then I expect this to be a relatively short-term issue.
- Economic Impact Risk: This considers whether the tariff policy could trigger an economic recession. If the tariff policy may lead to an economic recession, then I expect this to be a longer-term issue.
Therefore, the key question is whether the event risks will affect economic fundamentals.
Assessing the Impact on Economic Fundamentals
For investors, the core issue is assessing whether an event-driven risk, such as tariffs, threatens the fundamental health of the economy. This assessment is not binary but rather exists on a spectrum of probability. A strong indication of a threat to economic fundamentals signals a longer-term risk that necessitates proactive mitigation strategies. A short-term, manageable risk doesn't necessarily require immediate intervention.
Historical patterns from 2018 and 2019 demonstrate that when policy uncertainties are high but do not significantly threaten economic health, markets tend to recover quickly.
My Evolving Perspective on Tariff Risks
Before April 2nd, I underestimated the potential impact of tariffs, believing that the policy risk was contained. However, subsequent developments, such as higher-than-expected tariff rates and unexpected negotiation stances, shifted my perspective. These factors suggested a growing risk of the tariffs impacting fundamental economic health, prompting me to take immediate action.
Certainty and Reduced Recession Risk after April 9th
The situation changed again after April 9th. A clearer understanding of the boundaries of the tariff policy—its ceiling and floor—emerged. The confirmation of ongoing negotiations and the Trump administration's commitment to maintaining the stability of the bond market and the US dollar provided much-needed certainty.
This clarity addressed earlier concerns about potentially limitless and irrational threats, establishing a framework for better risk assessment. Though challenges remain, such as the increased level of US-China conflict, the risk of a recession appears to have decreased.
Ongoing Challenges and Risks
However, some challenges remain:
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Business Confidence: Businesses are wary of policy instability, making it difficult to plan. Examples such as factory closures highlight the impact of policy uncertainty on business confidence.
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Inflation: Inflation remains a threat, and the Federal Reserve's actions could further impact the situation.
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Policy Risk: Overall, policy risk remains high, requiring ongoing vigilance and a preparedness to address potential escalations that could lead to a recession.
Current Market Outlook
Currently, the risk landscape suggests a shift from long-term to shorter-term risks, implying a potentially faster recovery if the situation persists. For investors, the immediate priority is controlling short-term risks to avoid significant losses.
The Potential for a Structural Bear Market
While a cyclical bear market remains possible, a structural bear market is also a possibility. The worst-case scenario involves a loss of confidence in the US dollar and US Treasury bonds, leading to a sustained period of declining stock and bond prices and rising interest rates. This would fundamentally challenge the US exceptionalism that supports high equity valuations.
Everyone needs to assess their personal situation to determine whether a cyclical or structural bear market will impact them.