Several Factors Argue for Caution… But May Not Be the Ones You Think


As investment strategists, we don’t try to predict specific market behavior even in uneventful environments. Currently the nation is gearing up for a potentially contentious mid-term election amid rumblings about trade wars and likely interest rate increases. But those aren’t the reasons we recommend a cautious approach to the balance of 2018.

News vs. Noise 

Considering what could happen is an important part of good investment strategy. But without the context of knowing what is happening – and how that compares to historical norms – it can easily become counterproductive. Take for example recent headlines about new tariffs on imports and a possible multi-front trade war. While speculation and projections paint a pretty scary picture for the consumer and certain industry sectors, the impact on the U.S. economy and jobs market is something we can’t reliably predict at this point. We do know economic fundamentals finished the first half of the year strong and unemployment was at an 18-year low. The macroeconomic factors we pay attention to haven’t changed direction. In a historical context, there is room for the economy to continue growing and current trends seem to indicate it can. So we rate economic fundamentals as a positive factor in our outlook.

Don’t Fear the Fed 

Federal Reserve policy as it impacts interest rates has been another recent source of media fodder as the Fed announced its second rate increase of 2018 in June. Such news usually tends to rattle bond investors, and stocks have definitely benefitted from the historically low rates of the past decade. But it’s important to keep in mind that even with two more increases planned for the year (if economic strength holds up), from a historical perspective the Fed is still normalizing rates, not targeting new highs. For that reason we continue to rate monetary policy as neutral.

Bruce Bittles
Bruce Bittles
Chief Investment Strategist
William Delwiche
William Delwiche, CMT, CFA
Investment Strategist

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
Daily moves on S&P 500

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.

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