There are many dangers in the share market, that's why equities are higher risk than cash in the short-term.
However, there is one thing in-particular that I think investors need to be wary of.
Debt
The global economy has gorged itself on debt with record low interest rates around the world. Debt has been priced so low that it made sense to expand without a lot of thought, particularly in international markets like the USA. Mergers and acquisitions were touted as great moves for shareholders, but it didn't do much for growing the economy.
After several years of debt-fuelled growth, balance sheets are looking quite stretched with debt ratios compared to historic norms.
High debt isn't necessarily a bad thing if interest rates stay at record lows. However, the Fed has already started raising interest rates which has filtered through to our local banks like Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) raising interest rates.
The problem
As interest rates rise it can hurt shares in two different ways.
The first is that it will cost our businesses more in an interest expense. A company or real estate investment trust (REIT) might have an average interest rate of 4% on its current debt and the rate could raise to 5% or more.
A change of 4% to 5% doesn't look like a huge change, but it's actually adding a quarter (25%) more interest, which can hurt a business' bottom line.
The other issue is that investors will be more attracted to cash if they can get a better return on cash or bonds. This effect will make investors pull their capital out of the share market and put it into safer assets that are now earning higher returns.
The combination of this could see businesses have lower earnings and investors willing to pay a lower multiple for the earnings, which would see price/earnings ratios come down.
What to do?
There is no simple answer and everyone has a different idea. Some think that interest rates will stay low for a very long time to come, so we should simply keep on investing as we have.
Others think that a large correction is just around the corner and it's time to keep a large stockpile of cash on the side.
I think the best thing to do is keep investing in good businesses like Ramsay Health Care Limited (ASX: RHC) and Altium Limited (ASX: ALU), keep a bit of cash on the side and scrutinise potential investments just a little bit closer.
