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Portfolio > ETFs > Broad Market

Markets Surge, but the Fog Thickens

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Will this be the year the bull market finally ends?

Despite the fact that 2019 began with the strongest start to the U.S. equity market since 1987, there is no consensus on the future of the bull market. Main Street and Wall Street are going in very different directions. The economy continues to look strong, with low unemployment, rising corporate earnings and strong consumer confidence; yet financial markets are very jittery, with volatility rising, earnings forecasts declining and pricing that reflects the higher risk of recession by taking into account last year’s nearly 20% decline.

Market corrections (declines of 10% or more) typically occur once a year. Over the last 80 years, there have been just 12 recessions — but more than 43 greater-than-10% market corrections.

We believe the financial markets overreacted with the severity of the drawdowns last year, and we do not see signs of an imminent recession this year. Still, that drove the probability of a crash and recession a little higher than it was 12 months ago, so investors should position their portfolios accordingly. Diversification is key.

In retrospect, the fourth quarter 2018 sell-off was provoked by three factors:

  • Continued U.S. economic growth — but at a slowing rate;
  • Fading effects from the fiscal stimulus of the sweeping tax overhaul passed in 2017;
  • Geopolitical uncertainty (tariffs, Brexit, government shutdown, monetary policy shifts).

These issues are unlikely to be fully resolved over the next few months, so investors should be prepared for more volatility and drawdowns as the market continues to reprice risk. But on the positive side, these risks can create opportunities for long-term investors.

Secular shifts in the relationship between stocks and bonds, coupled with equity market volatility increases, suggest that investors may want to look beyond traditional portfolio construction approaches and traditional equity exposure. Many have begun reconsidering the traditional 60% stock/40% bond portfolio. At the asset allocation level, they’re thinking about alternatives to gain exposure to truly uncorrelated return sources. And within the equity sleeve, they’re adjusting to address the increased beta and volatility associated with factor and sector exposures.

Timing the markets is incredibly difficult. This points to the need for an investment strategy that focuses on preparation, not prediction. Investors should look for higher quality earnings, consistent dividend payments and more inelastic demand — but pay close attention to valuations.

We advise investing in companies that can be considered “defensive” across sectors. Utilities and real estate are traditional choices, but defensive companies can also be found in health care, consumer discretionary and other sectors. History has shown they will generally continue to participate in the equity rally while being less sensitive to market volatility.

Times like these expose the vulnerabilities of high-flying stocks. Crowded and highly valued sectors such as technology can be more vulnerable during market corrections. Witness what happened to the technology sector in the fourth quarter of 2018: It declined over 17%. Five big tech stocks accounted for much of the S&P 500 rally in 2018, and when they declined, the market followed.

Ultimately, sell-offs are reminders of the value of diversification, which has been obscured by this narrowly driven rally.

Michael LaBella is the Head of Global Equity Strategies at QS Investors, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.


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