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Portfolio > ETFs > Broad Market

What's Next After Last Week's Market Rout?

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The rebound in the stock market on Friday was a welcome relief to investors and advisors who had seen the Dow Jones industrial average and S&P 500 drop more than 5% in the two preceding days, but it’s not clear all clouds have lifted.

Aside from overvaluation, especially of some sectors like technology, some of the catalysts behind last week’s rout remain: the escalating trade war with China, excessive leverage in the corporate bond market and rising interest rates though the 10-year Treasury yield, which ended Friday at 3.16%, below the 7 1/2-year high of 3.25% posted Monday.

By week’s end, the S&P 500 and Dow were both down 4% for the week, three-quarters of S&P 500 stocks were priced 10% or more under their 52-week highs and the index closed just above its 200-day moving average, which it had crashed through during the two-day rout.

“It could go either way,” says Brad McMillan, chief investment officer offor Commonwealth Financial Network. But he says Friday’s rebound with “enough buyers to overwhelm a wave of selling and comfortable going into the weekend with risk assets” signifies the panic selling is over. “If we’re not done yet, we’re probably close.”

Goldman Sachs strategists, led by David Kostin, also foresee “limited further downside,” based on market fundamentals, according to their latest market note. Earnings growth, which averaged 25% during the first two quarters, is expected to climb 21% for the third quarter, return on equity excluding financials is at a record high of 20.7% and lower corporate tax rates all augur well for large cap stocks, according to Goldman.

In addition, Goldman economists give low odds — 37% — of a recession during the next three years, and its strategists expect a limited increase in interest rates. They’re forecasting the 10-year Treasury yield ends the year at 3.1%, slightly below the current level — and at ends 2019 at 3.4% since inflation, based on the core Consumer Price Index, is up just 2.2% this year.

But Goldman strategists also note that S&P 500 earnings per share could fall to $159 from an expected $170 if the U.S. imposes tariffs on most if not all of the $267 billion it has not already targeted but President Trump has threatened.

If nothing changes, the U.S. is also on track to impose 25% tariffs on $200 billion worth of Chinese imports starting Jan. 1, 2019, more than doubling the 10% tariffs already imposed on those imports.

In addition, there are concerns that U.S. tech companies may have to recast supply chains following reports that Chinese suppliers inserted microchips into hardware used by U.S. tech companies, says McMillan. Bloomberg News had reported that Chinese manufacturers had inserted microchips in hardware used by Amazon Web Services and Apple, but the two companies have denied the reports.

McMillan says investors should treat last week’s selloff as a “dry run” for a true bear market, checking if they’re comfortable with the risk they’re taking. Investors may also want to consider taking some gains off the table and use this time as an opportunity for rebalancing, says McMillan.

He suggests investors should consider the risk in their bond portfolios and favor high-quality issues with durations no longer than five years. “You’re not paid for the risk.”

Goldman strategists recommend that stock investors focus on companies with strong balance sheets and return-on-equity growth. They publish a list of 50 stocks they forecast will have the fastest ROE growth during the next 12 months. The median ROE expansion of the group is 23% versus 2% median for the S&P 500. Among the 50 are Alphabet and Apple, Nike and Whirlpool and Aon and Bank of America.

Advisors who responded to this reporter’s query about how they’re handling last week’s market decline with clients all noted that their clients are sticking with their investment plans. “If a client has a proper portfolio allocation based on the goals, risk tolerance and time horizon, then there’s no need to make significant adjustments to a client’s portfolio during times of market volatility,” wrote Drew Feutz, an advisor at Market Street Wealth Management Advisors in Indianapolis, Indiana. “A client’s portfolio allocation should have market volatility factored into it and should be appropriate for their specific situation.” 

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