Are Investors Playing Chicken?

The first half of the year produced robust gains for the stock market, with the S&P 500 advancing by 9.3%, thanks largely to healthy corporate earnings. In fact, according to estimates from S&P, trailing 12-month GAAP earnings through June are expected to be about 21% higher than over the 12-month period ending in June of last year. However, top line growth is far less exciting – sales grew at about half the rate of earnings in Q1 – and is fighting a headwind of decelerating GDP growth, which has gone from 3.5% in 3Q16, to 2.4% in 4Q16, and to just 1.2% in 1Q17.

Further, the New York Fed’s “Nowcast” is forecasting GDP growth of 1.9% for the second quarter and 1.6% for the third quarter. This isn’t the growth profile that many expected in the early days post-election, and with the Fed poised to begin shrinking their balance sheet in the coming months, longer term rates could move higher, which may hinder growth.

With that as the backdrop, we’ve noted from conversations we’ve had with advisors that there seems to be little impetus to make changes to portfolios at present. Few seem to be taking risk off the table, despite the fact that valuations on U.S. stocks are quite rich. Indeed, the cyclically adjusted P/E on U.S. stocks stands at just over 30 currently, and it’s only been higher twice, in 1929 and in 2000. Add to that the fact that economic indicators continue to surprise on the downside and you have to wonder what investors are basing their continued enthusiasm on. We suspect that the fear of being left behind is keeping many investors with the peddle down, but when somebody flinches, this may not end up being an effective approach.

Our capital market assumptions indicate that a standard 60/40 portfolio will return approximately 4.7% annualized over the next 5 years, assuming that valuations do not revert to the mean. If valuations do revert, and they will at some point, the outlook gets ugly. While valuation is not a strong short term timing tool, the starting point in terms of valuation is highly predictive of long term returns. Take a look at the following chart, which shows beginning P/E ratios and subsequent 10-year returns.

As one might suspect, investing in expensive markets doesn’t typically have a big payoff.

So what are investors to do? Fight the tape and lose out on the potential for further gains, or let it ride and assume the risks that come with such an approach? We think investors need to err on the side of caution, selecting strategies that provide true diversification and/or downside protection. We’d be paying particular attention to downside capture ratios when selecting strategies at this stage in the cycle. For our money, we don’t want to be loaded up on assets that will go down one for one with the market. Risk management will matter again, and it pays to be prepared.

Read our article, How to Identify True Diversifiers