The last five years have been anything but typical for stocks. Here are 4 factors that point to a bumpier market ahead, and 4 ways investors can prepare for it.
It's hard to believe, but the bull market is now five years old. From the lows in March 2009, the Standard & Poor's 500 Index ($INX) has advanced over 180 percent in what is now one of the longest and strongest bull markets in history.
Given this extraordinary advance, it is tempting for investors to rest on their laurels, expecting more of the same going forward. However, I would caution against such complacency as the next five years are likely to look quite different than the last. Let's review some important market factors.
Stocks were unquestionably cheap in March 2009. Economist Robert Shiller's P/E 10 or "CAPE" ratio, which looks at real price-to-earnings ratios of the S&P 500 over a decade, was a low 13.3, meaning stocks were priced to deliver above average returns going forward -- and this is precisely what occurred.
Fast-forward to today and you have the opposite setup. The Shiller P/E 10 ratio now stands above 25, well over its historical average, with stocks priced to deliver below-average returns going forward. Although this is not a short-term signal of market performance, this valuation metric has been one of the best predictors of long-term returns.
In March 2009, bearish investors outnumbered bulls by over 20 percent in the Investors Intelligence Sentiment Poll, which is a collection of forecasts by investor newsletter writers. Few people were expecting positive returns for equities in the year ahead. Entering this year, we saw the polar opposite. The bulls outnumbered the bears by over 45 percent in the same sentiment poll, which is an extreme reading historically.
Sentiment is an important factor to monitor because at sentiment extremes, the market often moves in the opposite direction of the crowd. Our studies confirm this, as forward returns are best when there is a high level of bearishness in the Investors Intelligence Poll. When there is a high level of bullishness -- as there is today -- few are left to buy, and forward returns tend to be below average.
In March 2009, the U.S. economy was also at the tail end of the worst recession since the Great Depression. Equity markets often post their best returns at the end of a recession and beginning of a new expansion, and we saw just that in 2009.
In June of this year, the economic expansion will hit five years, or 60 months. According to the National Bureau of Economic Research, the average expansion since World War II has lasted 58 months. We are therefore long in the tooth of this expansion.
That is not to say that this cannot be an above-average expansion, but that we are more likely to be closer to the end of the cycle than the beginning. This is important, as the most severe and lengthy bear markets are historically associated with a recession.
In the early spring of 2009, the Federal Reserve was still in the early stages of implementing what would become the most aggressive monetary policy in history. Fast forward to today and interest rates are still at or near zero and we are on the third round of quantitative easing. The Federal Reserve is expected to continue to wind down this latest round of quantitative easing this year, at which point the focus will shift to potential changes in the federal funds rate.
Though we'll never know exactly how much easy monetary policy contributed to stock market gains over the past five years, few would deny that it has been an important psychological factor. Without this psychological support system in place, investors should at the very least expect to see higher volatility in the markets. When the first round of quantitative easing and the second round of quantitative easing were wound down in 2010 and 2011, we saw just that. Volatility rose in those years and we witnessed sizable corrections of 17 percent and 21 percent in the S&P 500 index.
Investors need to understand that the last five years are not a typical five-year period and that the next five years are unlikely to look the same. Given the prospect of increasing risk and volatility in the equity markets going forward, investors should consider taking some of the following steps:
1. Rebalance your portfolio. Given the extraordinary stock market gains, investors are likely holding a higher percentage of equities today than their risk tolerance dictates. If they haven't already rebalanced their portfolios by reducing equity exposure and increasing exposure to other asset classes, now would be an appropriate time to do so.
2. Increase quality. Now is not the time to swing for the fences by choosing speculative names. Increasing exposure to high quality, larger-cap names that tend to hold up better during periods of market stress is a prudent move given the above factors. Additionally, as many experts view U.S. small-cap valuations to be among the highest in the world, lightening exposure to this area of the market could help reduce volatility going forward.
3. Go abroad. Although U.S. stocks are near all-time highs and at the higher end of their valuation spectrum, this is not true across the globe. In many emerging markets in particular, stocks have declined over the past three years and are at the lower end of their valuation spectrum. Increasing exposure to these areas could help boost long-term returns.
4. Raise cash or look to alternatives. There are few asset classes that can offer true protection during a volatile period for equities. Cash and uncorrelated alternative investments are two areas for investors to consider, especially for those investors nearing retirement who cannot withstand a large decline in their portfolio.
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