Market Views: Preparing for the next US stock drop
The US stock market has made its comeback.
Having risen 17.27% since January, S&P 500 closed at its highest level last Friday for this year. So did Dow Jones Industrial Average, which has gradually climbed back up and grew 13.79% as of Friday. It followed the selloff in December last year that saw its returns drop by 5.97% and shook investors' confidence in US shares.
Strong US economic growth data has supported the rally as real gross domestic product was up 3.2% in the first quarter in 2019.
While the rally is driven by a mix of favourable factors, economists have voiced concerns over the nature of it. Erik Nielsen, chief economist for UniCredit, an Italian financial services firm, noted that the new record highs of US stocks were “a bit of a sugar high”.
It’s also worth noting that even though the Federal Reserve took a dovish stance earlier in March – signaling the end to tightening its balance sheet and that it will hold off increasing rates – the Federal Open Market Committee will convene for a two-day meeting on Wednesday on potential policy changes.
The questions then remains: how long will the robust market carry on and what are some of the headwinds for the rally? What could asset owners do to prepare for an abrupt downturn?
AsianInvestor asked five industry specialists to share their thoughts.
The following extracts have been edited for brevity and clarity.
Ireneus Stanislawek, equity strategist
Vontobel Asset Management
US stocks have reached a new high, but this means nothing without putting it into perspective. The forward P/E ratio of US stocks is currently around 17 times and the equity risk premium compared to 10 year Treasury inflation-protected securities is at around 5%. Therefore, on spot, the market has more upside.
The length of the rally will depend on the length of the economic cycle and on the extent of the Federal Reserve’s dovishness. The most favorable environment for equities would be a persistently dovish Fed policy – willing to accept inflation running above target and depressing real rates. This would make the risky assets even more attractive and push the stock market higher.
Economic indicators outside of the US point to a less rosy picture. Global trade war worries are also not “off the table.” Further, as much as the U-turn of the Fed fueled the equity rally, a sudden switch to more hawkish mode would likely kill the rally. This is the flipside of the coin, especially taking into account market expectations of a further rate cut.
In case of a downturn, the “safe heaven” US dollar, as well as US bonds, offer good upside as they are considered liquid and relatively safe assets. Within stocks, the health care sector, which has been 'left behind' in the recent rally, could offer compelling relative safety.
Rick Singh, portfolio manager
JPMorgan Funds – US Opportunistic Long-Short Equity Fund
There are multiple reasons behind the strong rally experienced so far in 2019: the Federal Reserve pausing on interest rate hikes, expectations of an upcoming trade deal between China and US, oil price continuing to rebound, China’s growth stabilising and the fact that US growth remains relatively robust and investors realized there is no sign of an imminent recession around the corner.
However, given how fast the recover materialised, if the stock market is going to stay at (or above) the current level, underlying earnings will have to help move the S&P 500 Index forward…Our research analysts’ estimate for S&P 500 Index earnings currently projects 4% growth for 2019 and 10% growth for 2020.
We continue to watch closely the trade narrative, movements in global economic growth, and the implications of Fed policy, all of which have the potential to add to volatility. In the near-term horizon it is hard to identify many risks …The potential risk stemming from auto tariffs should not be underestimated.
Finally, global central bank balance sheet expansion peaked in 2017, and while money is still coming into the economy at this point, the planned trajectory of policy means that central banks will begin to take money out in aggregate. As a result, that protective cushion around corporate earnings growth is about to be removed.
Investors worried about potential drawdowns can take the opportunity to shift part of their equity allocation into liquid alternatives strategies …Examples of such strategies can be found both in the long-short space, as well as in the long-only space (think about equity portfolios combined with a hedging strategy based on options).
Kristina Hooper, chief global market strategist
Invesco
The current US stock market is not on a “sugar high” – I think that’s too strong a term. But there are some animal spirits at work, brought on by the dramatic change in the Fed’s monetary policy stance. I believe as long as Fed accommodation lasts, stocks will be supported – although we may not see significant gains from here as we need to digest the rally we’ve already experienced.
Stretched valuations are a headwind, as is the potential for an earnings slowdown. In addition, a deterioration in the trade situation could also trigger a sell-off.
Investors can include exposure to the low volatility factor in their portfolios. In the fourth quarter, that factor outperformed in the face of the abrupt market sell-off. Also, investors should be well diversified. That means diversification within equities and diversification within fixed income.
Investors should also have exposure beyond just equities and fixed income – they also need to have exposure to alternative asset classes in their portfolio, which have historically had lower correlations to traditional asset classes and can therefore help smooth out volatility. In addition, active management has historically offered some downside protection relative to indices in the face of a downturn.
Julian Cook, portfolio specialist, equity division
T. Rowe Price
For context, the US market has just recovered the ground it lost in the latter stages of 2018, the 20% declines the market experienced in the fourth quarter of 2018 have been largely reversed.
As surprising as it may seem with the US market approaching new highs, valuations do not appear to be elevated. At the end of March 2019 the Russell 1000 Index was at a 4% premium to its 20 year average when looking at the price earnings ratio of that benchmark. This obviously does not tell the whole story as the market is made up of very different companies and those that led the declines did not necessarily lead the recovery.
By our estimation approximately 30% of the S&P500 companies are facing serious secular challenge.
Even within technology, there are secularly challenged companies as well as heavily cyclical semiconductors, high growth secular winners, and a variety of business services companies all with very different characteristics and very different drivers to their performance.
One should not underestimate the impact of other parts of the market on the performance over the last decade and assume it has only been about technology. Steadily compounding growth stocks...can be very powerful contributors over the long term. Consumer discretionary companies have also been significant drivers of S&P500 performance.
There are the usual concerns that exist for any rally in the market, at this moment you could include the possibility of trade wars, a sharper than expected slowdown in the global economy, potential earnings disappointments and technology company regulation
Perhaps the largest recent change that is causing a significant headwind in the market is in the Healthcare sector. The hopeful 2020 Democrat presidential candidates are setting out their stalls a year earlier than most would have predicted. As such, the healthcare sector has come under increasing pressure as two of the Democrat candidates have discussed the possibility of a Medicare for All (M4A) plan if elected in 2020. It must be accepted that there is now a tail risk to the sector (however small) that will continue to weigh on healthcare stocks in the near term.
It is incredibly difficult for asset owners to fully insulate themselves from an abrupt downturn in the market. An indiscriminate sell off in the market will undoubtedly hurt returns initially but will also provide some inefficiency to the market.
Ritu Vohora, investment director
M&G Investments
The record high for the S&P 500 index marks another milestone for the most unloved bull market run in history. With the stock market so distrusted by many investors, and positioning so defensive, the latest record for the index is perhaps a pyrrhic victory. But since the beginning of this current bull market, just over 10 years ago, the S&P has delivered a total return of 436%.
The key question is whether this bull market has longer to run, and to what extent the current raft of US corporate earnings announcements will point to a further slowdown in growth.
For now, the US Federal Reserve’s reversal on interest rates, from aggressive tightening to a willingness to be more flexible and data dependent, has created a risk-on framework for equities.
For bonds, the recent inversion in the yield curve, indicating fears of a recession, seems but a distant memory. On the currency front, the US dollar is relatively becalmed – a positive backdrop not only for US equities but for emerging market equities too.
Despite the record high for the S&P 500 index, global stocks continue to look attractively priced relative to bonds. The equity risk premium – the difference between the earnings yield on stocks and bond yields – stands at 5.7%. This is more than adequately compensating investors for the additional risk they require to hold equities.
Only time will tell when the long bull market runs out of steam and what will be the exact triggers for that. The key for investors is to focus on the fundamentals. Typically, in the late stages of a bull market and maturing economic cycle, quality companies with strong cashflows, resilient business models and wide economic moats are favoured.
Article updated to include contribution from M&G Investments.