Are we worried yet?
No, we are not. For months, we have viewed U.S. equities as overheated, as investors have become overly optimistic. So, this market pullback is not a reason for panic.
One of the issues that you run into when commenting on the capital markets is how quickly things can change on you. In the midst of writing a version of this article explaining how we expect greater market volatility going forward than the smooth ride we have enjoyed over the past 15 months, and the market beat us to the punch, as the S&P 500 fell 7.8% from its most recent high (as of February 5). Frankly, the market’s ability to humble us is one of the reasons why we don’t write these pieces more than once a quarter.
At this point, we would categorize the stock pullback as minor, but swift. Historically, the S&P has experienced a 10% decline on average once a year. However, the S&P hasn’t had such a drop that big since early 2016, so we have believed for several months that the market has been due for (at least) a consolidation.
In our last note, we wrote about the maturing bull market in equities, as investors had become ever more bullish, even in the face of elevating macro risks. Market participants were the most optimistic they had been in the recent past (particularly as it relates to the U.S. equity market), and there were far fewer sidelined investors. Most folks decided to go all-in on equities last year because of persistently better-than-expected economic and earnings growth, a deliberate Fed (along with flat long-term bond yields), and the global expansion of the business recovery to most parts of the world. Investors extrapolated the business expansion and corporate profits into the future, believing that both will prove durable, and thus were more willing to bid up valuations. From the standpoint of a contrarian investor, this looked like a negative.
Over the last year, we have scaled back the overall equity exposure in client portfolios, while lightening up on U.S. stocks, adding to developed international equities and maintaining an overweight equity exposure to the emerging markets, particularly in Asia.
So where does that leave us now? We believe that there is still no evidence yet of a sufficient catalyst to begin a bear market, but further near-term shakeout is distinctly possible. We therefore feel that it is prudent to rebalance portfolios and to be true to our long-term asset allocation targets, as well as to be more selective in holdings and positioning.
Last month’s corporate tax cut will boost S&P 500 earnings and stock prices moderately in 2018. Much of the boost will be front-loaded in the first quarter as the benefits of the tax plan are reflected in consensus profit forecasts. Looking further out, we think that U.S. stocks will still have positive returns this year, but less than what we have experienced the past few years, as the increase in earnings will be offset by some valuation de-rating as U.S. interest rates rise.
Globally, government bond yields are rising more steadily, which should temper the pace of price appreciation for equity markets and lead to an increase in financial market volatility around the world. As such, investors will need to become more selective in their holdings. U.S. equities have largely led the global benchmark since the 2008-2009 Financial Crisis. However, U.S. relative performance, valuations and earnings are stretched from a longer-term perspective. Consequently, equity portfolio values have grown and we are rebalancing our overall exposure, consistent with long-term allocation targets. Furthermore, we are continuing to rotate exposure away from the U.S. equity market and into more global equities. This all began at the beginning of 2017 (albeit in a selective way) due to our view that the global growth was strong enough to support a pickup in the trade cycle. Emerging Asia and European equities remain more attractive.
We stress that the economic cycle is not drawing to a close. The global economy is in good shape and U.S. growth is still biased to surprise on the upside in the next year. China is destined to slow, but the long-feared hard-landing there is not in sight. Europe’s recovery is still broadening. Our asset allocation changes should be put into context. We continue to advocate owning equities. The U.S. earnings outlook is favorable, but earnings for non-U.S. markets are poised to outperform the U.S. against the supportive global backdrop.