Investing in the second longest equity bull market can rattle the nerves, especially now given the frequency of wild one-day swings.
Since the beginning of the year there have been approximately 60 trading days when the Dow Jones industrial average has moved at least 200 basis points in one direction or another, including many days when the swings were twice as large.
“This is not playing out like a typical cycle,” says Tracie McMillion, head of global asset allocation strategy at Wells Fargo Investment Institute and one of the authors of its report, Investing Late in a Bull Market: Essential Strategies for Today’s investor.
In most bull markets, for example, the sectors that perform best late in the cycle are energy, materials and industrials, according to McMillion, but except for industrials that is not the case now, at the beginning of the bull market’s tenth year.
The sectors performing best are technology and health care, which are each up about 3%, followed by financials and industrials, which are down about 1%, according to the latest S&P 500 sector indexes.
McMillion likes consumer discretionary and industrials, which tend to perform well when the economy is doing well, and she’s expecting 2.9% GDP growth for 2018. She also expects the bull market will extend well into 2019, with another 7% to 9% gain this year due to the recent corporate tax cuts.
The average return of large-cap stocks one year before a bull market ends is just over 24%, according to Wells Fargo Institute and Morningstar Direct data based on monthly from August 1926 to September 2007. The average gains for small-caps during that period topped 36%.
Despite these still-bullish data points, McMillion recommends that investors be on the watch for signs that could signal the beginning of its end, including:
- An inverted yield curve. Every recession since 1955 was preceded by an inverted yield curve by six to 24 months. The yield curve isn’t inverted yet — the yields of long-term bonds are higher than the yields of short-term debt — but the spread between the two has been narrowing. The spread between the two-year and 10-year Treasury notes is current about 45 basis points, less than half the 104 basis points of one year ago.
- Rising inflation. The Personal Consumption Expenditures index rose 2% year over year in March — its biggest jump in 13 months — and core PCE, which excludes food and energy and is the Fed’s favorite inflation indicator, increased 1.9%, approaching the Fed’s 2% target.
- Rising wages. This is a key driver of rising inflation, and according to the latest (March) jobs report from the Bureau of Labor Statistics, average hourly wages rose at an annual 2.7% rate — slightly below the 2.9% and eight-year high reported for January — but still climbing comfortably higher.
- U.S. tariff policy. New tariffs of 10% on aluminum imports and 25% on steel imports are expected to increase the price of products that use those imports in their manufacturing processes, such as cars. So far the White House has exempted many countries from the tariffs including Canada, Mexico and members of the EU, but that exemption, which has been extended, expires again on June 1, and other trading partners like Japan and China have not been exempted. The White House has also proposed additional tariffs of $50 billion or more on Chinese imports, which prompted China to threaten to retaliate in kind.
- Macroeconomic developments and the stock market. “Watch the fundamentals” and whether the stock market is weakening, says McMillion.
- Midterm elections. “Every midterm election year since 1962 has had stock market corrections, which averaged 19%,” says McMillion. The S&P 500 typically sells off early in a midterm year, ending the first three quarters flat to slightly lower, and rallies in the fourth quarter, according to Wells Fargo data. Since 1962, fourth-quarter returns for the S&P 500 Index during midterm election years have averaged 7.5%. When the president is a Republican and the Democrats take over the House — which happened in 1982 and 1986 — the S&P 500 gained close to 15%. When Republicans held the White House and the Democrats controlled both houses of Congress — in 1970, 1974, and 1990 — the S&P 500 ended flat or lower, falling as much as 30% in 1974, when the economy was in a severe recession.
As investors remain on the lookout for those potential developments that could suggest the bull market is near its end, they should also position themselves for potential rising volatility, says McMillion. She recommends that investors:
- Revisit asset allocation. Is it still appropriate for the investor’s time horizon, risk tolerance and how did the current allocation perform during the Great Recession in 2007-2009?
- Rebalance regularly to insure the allocations correspond to an investor’s investment objective. This means buying stocks on dips to maintain those allocations.
- Consider adding alternative investments like hedge funds to mitigate risks.
- Take advantage of tactical opportunities such as buying equities on dips and shortening bond maturities. McMillian does not believe that investors should lighten up on equities in favor of bonds paying higher yields because the S&P 500 earnings yield is still well above the 10-year Treasury yield, but the earnings yield, now at a 4.11%, is inching closer to the 10-year yield at 2.97% (it had breached 3% recently, then retreated slightly).
- Globalize portfolios. Given that developed markets like the those in the EU and in Japan began their economic recovery later than the U.S. and are maintaining low interact rates while the U.S. is hiking rates, their stock market should continue to climb even if U.S. stocks stall, says McMillion. She suggests the investors allocate 20% to 30% of their portfolios to international equities.
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