Opportunity or Caution
There are times when investors should be more aggressive and times to be more conservative. History clearly shows that most investors mistime their aggression. They are scared to invest when the opportunities are greatest and eager to invest as the opportunities dwindle.
Investors have been overly cautious during most of the bull market, and worried more about preserving capital than searching for opportunities to grow. Individuals invested for “safe” fixed-income instead of stocks, and institutions underweighted publicly traded stocks for more expensive absolute return strategies.
The bull market is now more than 10 years old, and investors are finally coming out of their defensive shells. Their typical metamorphosis from bears to bulls once again seems ill timed. Rather than pushing money heavily into stocks, now is the time to have realistic expectations for stock returns take a more defensive approach.
Since the end of 2016, investor and Wall Street sentiment data show that the trend is towards overweighting stocks over bonds. In fact, investors are more bullish today than at any time in the past 8 years. Looking back over the past 30+ years, Wall Street recommended underweighting equities during the current bull market in the same way during the bull markets of the 1980s and 1990s. The only time the Street recommended overweighting equities was during and immediately after the Technology bubble of the late‘90s and early 2000s. US equities underperformed versus average returns during the following decade.
Research is showing that profit cycles are more influential to stock performance than are economic cycles. The US profits cycle is poised to significantly decelerate in 2019. Under generally accepted accounting principles, 2018 S&P 500 profits growth exceeded 20%. Now, analysts like Richard Bernstein are forecasting profit growth for 2019 will slow to between 0-5%. The risk of a full-blown profit recession could increase toward the end of the year.
History shows that it is generally beneficial for investors to rebalance their portfolios to their target stock allocation rather than taking on more risk during periods when profits decelerate. Riskier strategies tend to perform better when profits accelerate.
One should also be aware that liquidity is starting to dry up. The flat/inverted US yield curve reflects that the credit markets are starting to get more conservative. Perhaps more important, bank lending standards now appear to be tightening.
The Federal Reserves survey of senior bank lending officers shows that more lending officers are telling the Fed they are tightening rather than easing lending standards. This is the first time banks are tightening lending standards in roughly 3 years. The flat/inverted yield curve and tighter lending standards may be signaling that investors should be calming down rather than becoming more enthusiastic and taking more risk in their portfolios.
Investors are always the most bullish in the final stages of a bull market, and then subsequently regret their aggressive imprudence. The combination of decelerating corporate profits, liquidity that’s starting to dry up, and investors’ incremental bullishness is starting to signal that we should shift to a more cautious stance. No one knows when a significant and prolonged downturn may occur but it is usually better to be a little early in taking a more cautious approach to investing.