Beating the Fear Factor in Equity Markets

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By Sharon E. Fay, CFA

Today’s equity markets have all the makings of a scary movie. But don’t look away. Embrace uncertainty and adjust expectations to regain conviction in equities as a source of long-term returns.

There’s no shortage of worries for equity investors this year. January’s spike in volatility has scarred the market. The global economic growth outlook is shaky amid China’s slowdown. Stock valuations look full, and earnings are under pressure in a low-growth world. And there’s growing concern that if Britain votes to leave the European Union on June 23, markets could take another hit. No matter what type of investor you are, it’s hard to know how to proceed.

Adjusting Return Expectations

Start by adjusting expectations. After the global financial crisis, easy money policies from the major central banks fueled a multiyear rally in equities. As a result, valuations reached relatively high levels, particularly in the US, where the market’s price/earnings ratio (P/E) was 16.7 at the end of May—higher than in 64% of all months since 1996. European P/Es are lower, though slightly above their long-term average. Emerging markets, however, are still attractively valued after five difficult years.

But looking at valuations in isolation is misleading. For perspective, it’s important to assess the potential of equities in the coming years versus other investing options—and what’s likely to drive returns.

Since the global financial crisis, investors have become accustomed to unusually strong equity returns, with the S&P 500 advancing by an annualized 17.3% from 2011 through June 2015, driven by a recovery from a crash of historic proportions. But the recovery started to run out of steam last summer, and these returns aren’t likely to continue.

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