6 reasons to be cautious about stocks
U.S. equity markets keep reaching all-time highs. Bonds income is low and rising rates will make bonds less attractive in the near term. We are living in historic times: major U.S. stock markets are up over 260 percent since 2009. In the past 50 years, only two rallies were better.
But rallies do not just die of old age. Economic data points towards continued expansion, if somewhat tepid, and unemployment is low. Tightening by the U.S. Federal Reserve is likely to be measured and gradual – dovish – as global and U.S. inflation continue on low trajectories.
This has led to complacency among many investors, who generally need exposure to growth stocks in their portfolios to keep up with inflation and meet their investment targets. What can investors near or at retirement do to increase the certainty of meeting their retirement needs?
There are six big reasons to be cautious in their approach to investing in equities:
- Greed & Fear: Many investors tend to overshoot on the upside … and then overshoot on
the downside. It’s human nature, or as the Millennials say, FOMO (Fear Of Missing Out). Year-to- date, the S&P 500 Index has hit 29 new highs. Could it be over-enthusiasm?
- Sky High Valuations: Historically, the U.S. equity market is expensive. A high cyclically-
adjusted price-earnings ratio (CAPE) – as we currently have – often has led to low or
negative overall stock market performance in the future, unless there is strong reason
for the rally to continue.
- Slow Global Economic Growth: Most forecasters, the U.S. Federal Reserve and World
Bank included, expect global GDP growth in the 2-2.5 percent range. Some foresee as
little as 1.6-1.8 percent. Slow growth and high valuations make a bad mix.
- Political Gridlock: If Congress and the President cannot reform health care, can investors
expect sweeping tax cuts, let alone major infrastructure initiatives? Without a stimulus,
growth is highly unlikely to reach 3-4 percent, as the Administration targets. Scandals
could lead to “blonde swan events.” The “Trump trade” has mostly unwound, making it
important to focus on fundamentals.
- Possible Fed Missteps: 80 percent of Fed tightening cycles have led to recessions. (Scary
and true.) A recession may not be likely soon, but if poorly managed, we could get
closer. The good news is that gradual rises in interest rates often have not had outside
impacts on defensive sectors.
- Tick, Tick, Tick … Boom?! The S&P 500 has risen over 260 percent since 2009, the last
year we had a bear correction (a drop of 20 percent or more). Since 1950 the S&P 500 has fallen 35 times by 10 percent or more. Given the market’s high valuations and mediocre economic growth, we may be overdue for a correction – possibly a big one.
We believe this can be a good time to be smart, take some profits and reinvest in value-oriented defensive equities with solid earnings. Investors should consider to prudently reallocate and be wary:
- Diversify: After years of underperforming, international developed and emerging
markets (EMs) are cheaper and growing quicker than the U.S. Buying stocks from these
regions can help capture growth at cheaper prices and alleviate any drawdowns in U.S.
equities. Investors should pay even closer attention to fundamentals when market risks
- Defensive Potential with Dividends: Many U.S. stocks, particularly technology, are
expensive. Cheaper defensive stocks in all sectors, with low price and earnings volatility,
have historically done well over the long-term, and can help manage downside risk.
Dividend-paying stocks can be great sources of income OR of total return, if reinvested
to buy more shares.
- Low Market Volatility May Be Meaningless – or Not: Market volatility is at multi-decade
lows. While not a bad thing, it can make it harder to identify risks and leave investors
over-exposed. For example, tech volatility has declined significantly, causing some low
volatility funds to increase exposure to the FANGs. They still have volatile earnings,
however, and may take bigger hits in a market correction. We expect them to be sold if
James Norman is President of QS Investors, a Legg Mason affiliate, His opinions are not meant to be viewed as investment advice or a solicitation for investment.