This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
As measured by Vanguard's Total Stock Market Index ETF, the U.S .stock market currently sits around 19.4% below its recent highs. That's still in the neighborhood of a bear market, and there are plenty of reasons to remain nervous. In particular, with the Federal Reserve making it clear it won't stop raising interest rates until inflation is under control, the downward pressure on stocks may very well continue.
That raises a key question: Is it safe to invest in the stock market right now? Well, the direct answer to that question is no. 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 falling market has opened up opportunities where the potential rewards are worth the risks you're taking. Through that lens, there just might be a path to where it might make sense to consider investing again.
Look where the fear is palpable
In a rising rate environment, some of the industries that get hardest hit are the ones that rely heavily on customers that need to borrow money to make their purchases. For instance, the S&P Homebuilders Index is down far 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 is absolutely true that rising rates make it tougher for people to buy homes, it's also true that permits to build new homes remain slightly stronger than they were this time last year. While homebuilding and home buying is decelerating, we're also coming off what had been an incredible housing boom, and one where demand far outpaced supply.
There's a wide gap between a tremendous boom and a complete collapse, and contrary to popular belief, people are still buying houses. It's just not at as fast a rate as it was during the peak of the low-interest rate fueled real estate mania. The question you should really be asking yourself is whether the market's palpable fear surrounding homebuilders has made at least some of them available at a bargain price.
On a related note, rising interest rates mean that companies that are in the business of lending money have the opportunity to earn more on their lending. For instance, even as consumers cost to borrow has gone up, the interest rates banks pay on savings remain stubbornly low. Even so-called "High yielding" savings accounts are barely paying above 2%, even as 30-year mortgage rates have climbed to around 5.66%.
One key way that banks make their money is off the spread between the rate they pay to depositors and the rate they lend out to borrowers. The higher interest rates are, the larger the potential room in that spread, which could ultimately translate to higher earnings for them.
Of course, the risk is that if too many people default on their loans, banks won't be able to collect enough from their lending to fully cover their costs. If the economy stays soft and job losses start to mount, that risk can become magnified. So while bank stocks are down, at least some of the worry is justified by the potential of things to go from bad to worse.
Are the risks and potential rewards in balance?
Neither homebuilders nor banks are risk-free investments, but both have generally seen their share prices fall as the market has started to recognize the risks that both industries face. As a result, investors buying today actually have a better potential reward profile for the risks they're taking than those who bought earlier when prices are higher.
Has the balance tilted enough in investors favor to where they may be worth buying? That's a little tougher to answer, but you can usually get in the ballpark. One great approach to do that is to use the discounted cash flow model to help you value any stocks you're considering buying. With that model, you can get a good handle on both the cash you expect a company to generate and what that cash is worth to you.
If the stock price looks cheap relative to value suggested by the company's cash-generating abilities, then the risk-reward balance may very well be in your favor. Even better, since you've built a model based on projections of the cash the company is expected to generate in the future, you can use that model to check up on the company as time progresses. That can help you keep an eye on any stocks you do buy to see if their businesses are truly worth holding on to.
Get started now
While down markets often provide chances to buy great companies at bargain prices, the market's panic likely won't last forever. Make today the day you start looking for bargains. Once you find them and buy them, have the patience to let the market work through the rest of its worries. Do that successfully, and you just might discover that while it's not safe to invest in the stock market now, it may very well turn out to be profitable.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
