Several Factors Argue for Caution… But May Not Be the Ones You Think
What the Market Is Telling Us
If you’re worried about the volatility we’ve seen in the markets this year, you’re probably thinking about it in terms of last year. As the chart below shows, you really shouldn’t. Last year was unusually quiet from a historical standpoint.
Number of +/- 1% Daily Move on S&P 500
2018 data through 6/30
Despite the return of more historically normal volatility, stock prices overall are still fairly high relative to corporate earnings. Those earnings were generally stronger than expected in the first half of the year, but not enough to make us comfortable with where stocks are priced now. Ironically, more volatility in the second half of the year might help bring prices into a more reasonable range.
We often measure the strength of a bull market by the number and variety of companies we see rallying (commonly referred to as breadth). But some consolidation of market “winners” isn’t unusual in a bull market. So, even though we’re changing our market breadth rating from bullish to neutral, we aren’t concerned that recent activity could spell the beginning of a bear market.
Optimism Can Be Problematic
While it may seem counterintuitive, historically the market tends to perform better when investor sentiment is pessimistic. Ignoring for a minute the reams of data analyzed to draw this conclusion and the various behavioral theories that try to explain it, let’s agree that when expectations are generally low there’s more room for pleasant surprises. Investors have been on an emotional roller coaster so far this year, swinging from record optimism in Q1 to deep pessimism in Q2. Lately bullish sentiment seems to be on the upswing (as reflected by weekly sentiment surveys and inflows to stock mutual funds). If historical patterns hold, this increases the risk to market performance in the second half of the year, leading us to rate current investor sentiment as a neutral factor in our outlook.
About That Election
We say it every election year, but it bears repeating: The market doesn’t like uncertainty. And the general sense of uncertainty in the United States tends to peak in presidential and congressional election years. Election years are often volatile for stocks and pullbacks in the fall aren’t uncommon. We currently rate seasonal trends as a negative factor but, if history is any indication, we would expect them to turn more favorable after the elections. We would also expect to see large cap stocks replace small caps as market leaders. Even with the potential electoral headwinds, we’re seeing relative strength and leadership in U.S. markets compared to the rest of the world.
The Bottom Line
There’s enough going on that we can see and know to make the argument for a more cautious investment approach to the back half of the year. So we see no need to get caught up in speculation over the unknowable. Your Baird Financial Advisor can help you develop an investment strategy and related plans to ensure you stay focused on your financial goals through the market’s unpredictable ups and downs.
Download this Wealth Management Outlook, complete with our Weight of the Evidence chart and financial planning calendar, in a printer-friendly format.