Over the last few months, we have written, spoken, and tweeted incessantly about the coming headwinds to both the global economy and the capital markets. In July, we noted that despite the current macroeconomic momentum, there are many factors that are likely to hamper growth by the time we get to late 2019 or 2020. These include tighter monetary policy that will actually begin to pinch growth, fading tax-cut and fiscal stimulus (especially if the Democrats take the US House of Representatives in the midterm elections), continued trade and export headwinds, a Brexit supply-shock to the United Kingdom and Europe, and so on.

Moving to the markets, we’ve highlighted that the easy money has already been made – simply pointing out that revenue growth is likely peaking, profit margins are more-than-lofty, and price-to-earnings ratios (P/Es) are elevated. This trifecta doesn’t guarantee equity losses, but the gravitational pull of these metrics does create a significant hurdle to future equity gains. But does this mean it’s time to get out of the market? We don’t think so.

Successful Market Timers Are Hard to Find
Given our outlook, we would love to be bearish. Bearish market calls, conspiracy theories, and doomsday scenarios are so much more interesting and intriguing than Wall Street’s conventional bullishness. One good bearish call on TV, lucky or otherwise, and your reputation as a market guru is cemented for life.

Sadly for some, that isn’t our style. For starters, jumping in and out of risky assets sounds a lot like market timing – not a skill we have lots of confidence in. Since 1970, global equities (as measured by the MSCI World Index) have generated an 8%+ total return at approximately 14% annualized volatility.1 This means a common range of returns, say plus or minus one standard deviation, would be anywhere from -6% to +22%. For any asset class with that level of volatility, this seems like a crapshoot. Moreover, if anyone had a crystal ball that accurate and was consistently great at market timing, surely we would have heard of them by now. Successful market timers wouldn’t need to advertise.

Long Odds
Other than a philosophical opposition to market timing, we also don’t like the odds that come with being outright bearish. Equity markets have a long history of going up more often than they go down. This is true both empirically and theoretically. The higher uncertainty implicit in “risky assets” (like stocks, commodities, high yield bonds, etc.) means that their prices are discounted accordingly (on average). For example, sitting at the bottom of the capital structure, equity investors generally discount prices enough so that, on average, accepting higher risk is commensurate with earning higher future returns. Many will find the actual numbers more compelling, so here they are for the S&P 500® in the post-war era.

Figure 1: S&P 500: Positive Returns by Frequency
Source: Morningstar, Natixis Investment Strategies Group, Jan. 1, 1946 – Dec. 31, 2017. Past performance is not indicative of future results.

History shows that stocks go up more (and more often) than they go down. That’s hardly a revelation, but it has some strong implications. Just like going to a casino, the odds are not in your favor when you jump out of stocks. Some gamblers leave the casino with more money than they came with. However, if this were true on average, casinos wouldn’t exist.

Does this math mean you can’t ever be bearish? No, but an investor should have fairly compelling evidence to justify trying to beat those long odds. What would cause us to become more pessimistic? Signs of greater inflation and/or wage pressure that would force the Fed’s hand and cut into profit margins. So far these warnings are flashing a faint yellow, but not red.

If Not Bearish, Then What?
To summarize, we are caught between a rock and a hard place. We believe the global economy is likely to slow in the next 6–12 months and that asset prices don’t fully reflect this. Regardless of the macro economy, an upside surprise in stock returns is unlikely with above average (and mean-reverting) revenue growth, profit margins, and price-to-earnings ratios. Conversely, our crystal ball isn’t good enough to time the markets and we don’t like the odds of making a big move to cash.

To cope with this, we believe investors can split the difference by being cautious instead of bearish. That is, stay in the markets, but with a lower risk or lower beta profile. Some examples might include…

  • Maintaining international equity exposure, so as not to be over-exposed to high-flying US stocks.
  • Rebalancing back towards value stocks, which will participate if markets trend higher but have a greater margin of safety if stocks slump.
  • Favoring senior bank loans over fixed rate high yield as they tend to have less volatility, better recovery rates, and sit higher in the capital structure.
  • Emphasizing greater liquidity (maybe some cash) so you have “dry powder” to take advantage of any dislocations.
  • Not giving up on hedged/alternative strategies this late in the cycle just because they “haven’t worked” (yet).
Our forecast is for a slowdown in global growth, but we do not yet see a recession on the horizon. We think market volatility is likely to remain elevated and equity gains will be tougher to come by, but can’t see a bear market yet. Given this, we think it unwise to try to squeeze every last dollar out of this 10-year bull market.
1 Source: Morningstar

MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is composed of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both US dollars and local currencies.

S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.

Beta measures the volatility of a security or a portfolio in comparison to the market as a whole.

Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.

Liquidity is the ability to convert an asset into cash quickly, with minimal impact on the price received.

High yield bonds are rated below BBB/Baa. Ratings are determined by third-party rating agencies such as Standard & Poor's or Moody's and are an indication of a bond's credit quality.

The price-to-earnings ratio, or P/E, is a measure of a company’s current share price relative to its per-share earnings, also known as the price multiple.

Volatility is the range of variation in the value of a security.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

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