Up! Buy the dips! What could possibly go wrong? A hell of a lot, actually, so investors might want to take precautions before, rather after, bad things happen to one’s portfolio. We take a stab at where one may find opportunities in 2016.

In an early August Merk Insight entitled Coming Out – As a Bear!, we argued rising “risk premia” could create headwinds to the stock market (and other so-called risk assets) for at least eighteen months, if not years. To understand what this means, consider that central banks have – in our view – taken fear out of the market, as evidenced by low yielding junk bonds and low volatility in the stock market, amongst others. The lack of fear in risky assets is another way of saying that risk premia have been low, or as we also like to put it, that complacency has been high. Not fully appreciative of this inherent risk, it seems many investors have refrained from rebalancing their portfolios, and bought the dips instead. We believe the Fed’s efforts to engineer an exit from its ultra-low monetary policy should get risk premia to rise once again, that if fear should come back to the market, volatility should rise, creating headwinds to ‘risky’ assets, including equities. That said, this isn’t an overnight process, as the ‘buy the dip’ mentality has taken years to be established. Conversely, it may take months, if not years, for investors to shift focus to capital preservation, i.e. to sell into rallies instead.

When we talk with retail and institutional investors alike, we hear that many like neither stocks nor bonds, but that they haven’t changed their investment strategies. The fear of losing out on the next rally appears to still be high. Yet, when we look at other parameters in the market, we can’t help but be pessimistic:

It’s no secret that the U.S. economy has not been firing on all cylinders; the global slowdown appears to have hit the U.S. as well, as we see, amongst other factors:

All of this unfolds despite low energy prices that, theoretically, should boost consumer spending. As ‘risky assets’ (most notably the equity markets, but also the high yield fixed income market, amongst others) in general have benefited from the low interest rate environment, those may be most at risk. When it comes to ‘systemic fallout’, i.e. the collapse of an institution, we don’t expect a major bank to fail. However, while regulations in recent years have coerced banks to take on less risk, such risk has moved to the shadow-banking sector. And while regulators have made the financial system more robust against some shocks they can imagine, we imagine any shock is more likely to come from places were we don’t expect it; more importantly, it may come from a place where the Fed might not be able to provide relief. Market jitters a few months ago because of losses at Glencore PLC, an Anglo-Swiss trading and mining company, come to mind as a possible candidate for turmoil in the market. Turmoil in a Chinese brokerage firm or some other obscure place could also be a source for trouble in the markets.