By James Norman, QS Investors President
With U.S. equity markets falling back from historical heights after nine strong years of returns, many investors are asking: where are the markets going? In the next week, the next month, the next year?
Even those of us who track these markets for a living must admit – we do not know.
This leaves investors facing a dilemma. How do investors increase the certainty of meeting their goals given potential headwinds and downside risks? Over the next several years, most of the investors we talk to expect U.S. equity returns to be lower than historical levels, and that both U.S. and global economic growth is unlikely to increase dramatically. In addition, high valuations combined with political and economic uncertainty compounds downside risks.
Yet investor obligations continue to mount, due to the rising costs of retirement and trepidation over long-standing social welfare programs, such as Social Security and health care.
What can we do when we don’t know? Lean on what we do know and try to increase the certainly of meeting goals.. Markets do not always go up. If we are moving into a time of corrections, it is best to be ready. We may have to change our mindset from trying to capture the highest level of gains on the upside to guarding against losses on the downside.
Here are three big things we know about U.S. equity markets:
- Valuations are High: As measured by the trailing price/earnings ratio of the companies within the S&P 500 Index, valuations are trading at a whopping 25 percent premium with respect to their 10-year average.
- Uncertainty is Growing: The Trump Administration has become bogged down by scandal allegations and unable to focus on initiatives investors want to spur growth (such as tax reform, infrastructure building and financial regulation reform). This is causing continuing and increasing political and policy uncertainty, which is roiling the markets.
- Reasons to Stay the Course: Confidence remains high and earnings growth is attractive.
What do we recommend to our investor clients? We suggest rotating to more stable, defensive parts of the equity market. Invest in stocks that are profitable with less earnings volatility – the safe harbors during equity storms. These should catch much of the upside (if the markets swing back and continues to achieve new heights) but avoid much of the potential downside if they slide further.
Investors who worry about the downside risk of equities have several options. First and foremost is diversification. We are fond of saying that “diversification is the only free lunch in investing.”
Low volatility equities also may help lessen the impact on investor portfolios from market drawdowns. These are typically companies whose stock price may grow more slowly, but they are often more stable, fiscally healthy and consistently pay higher dividends to shareholders. By employing caution and emphasizing quality companies, investors may miss out on some of the short-term high flyers, but they will be better positioned for success over the long term.
Our primary goal is to help investors stay invested, so they can reap its benefits over full market cycles. We do not want them to lose confidence after a series of quick losses, throw up their hands and exit the markets, never to return. That will not achieve their investment objectives, whether home purchases, college funding, business objectives or comfortable retirements.
As I write this at the end of the day, May 17, 2017, this day marked the worst one day fall for the S&P 500 Index and Dow Jones Industrial Average since September 9, 2016. NASDAQ realized its biggest decline since June 24, 2016.
The only positive sectors were Real Estate and Utilities. Banks were the worst losers, down 3 percent. High beta/cyclical stocks pulled back, while defensives did better.
The performance of several indexes on May 17 bears out the wisdom of switching to defense:
- S&P 500 fell 1.8 percent
- DJ Industrial Average lost 1.8 percent
- NASDAQ declined 2.6 percent
- CBOE Volatility Index (VIX) jumped 46 percent
Our conclusion: Despite strong fundamentals, U.S. equity markets are still susceptible to political crisis and uncertainty, underscoring the need for beta protection.
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.
All investments involve risk, including loss of principal. Past performance is no guarantee of future results. Diversification does not guarantee a profit or protect against a loss.