Presenter: Paul Christopher, CFA, Head of Global Market Strategy, Wells Fargo Investment Institute
If you’ve ever been caught off guard by rapidly changing weather, you know how important it is to be prepared.
Fortunately for us, meteorologists are constantly monitoring weather conditions, watching for any signs of instability.
We depend on them to keep us prepared whenever a storm is brewing.
[On-screen text: Paul Christopher, Head of Global Market Strategy, Wells Fargo Investment Institute]
Financial markets are not a force of nature like the weather, but just as we want to know when to pack an umbrella, investors want to know when a storm is brewing in the economy and how they should prepare.
Take the current economic expansion as an example.
The sheer length of our current expansion has made many investors increasingly anxious—wondering when the current recovery will end and the next market contraction will begin.
Much like meteorologists, we constantly watch for indicators and warning signals that can predict changes in the markets, and right now the indicators we’re watching don’t suggest it’s time to issue a storm warning.
But rather, we think a storm watch is more appropriate.
A watch usually means conditions are favorable, but there’s no imminent threat.
For investors, this means be prepared for a market downturn, but don’t overreact and let fear tempt you to abandon your long-term investment plan.
[On-screen text: Diversify across markets and types of investments]
We recommend broadening exposure across markets and types of investments—including alternative investments like hedge funds and private capital.
[On-screen text: Use cash as a tool]
Try to use cash as a tool—that is, put cash to work gradually and as market pullbacks create opportunities.
[On-screen text: Know what you own]
And know what you own. Focus on quality companies, and don’t fall for overinflated return expectations.
Unsettled weather is a natural part of the seasonal cycle that we all experience periodically.
And recessions are a natural part of an economic cycle that all investors should expect and plan for accordingly.
So don’t get caught without your umbrella.
[On-screen text: Download our special report]
To find out more about the investment strategies we think investors should use for weathering the storm of an eventual bear market, download our Wells Fargo Investment Institute special report: How Bull Markets End.
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During the latter stages of a bull market, investor overconfidence can lead to inflated market prices and, as in some recent cases, excessively high asset prices. The table below lists common factors that can lead to excesses over time.
Currently indicating a peak?
What we are seeing today
Heavy inflows into equity mutual funds
Equity mutual funds have seen persistent outflows in the past year
Rising real (inflation-adjusted) interest rates
Real U.S. interest rates are declining
Credit spreads widen sharply
Credit spreads remain contained
Exuberant investor sentiment
Sentiment shows some caution
Rapid growth in corporate mergers and acquisitions
Merger and acquisition activity has been rising since 2016
IPO activity is strong*
IPO issues have more than doubled from 2018 to 2019
Decelerating corporate earnings
Positive but slower earnings growth
Equity market leadership shifts to defensive sectors
In the past 12 months, the leading sectors have been Utilities, Consumer Staples, and Communication Services. The worst performers have been Energy, Materials, and Financials.
Sources: Wells Fargo Investment Institute, September 30, 2019.
* An IPO is an initial public offering of equity by a company.
Risk factors for a potential downturn
Recessions are not easy to predict, but we believe the specific headwinds of this cycle may provide investors with warning signs to monitor.
In 2019, rapidly growing investor demand for longer-term bonds drove their yields lower than those of some shorter-term bonds. This is a yield-curve inversion, and it can push the rates that banks earn on long-term loans lower than the short-term rates that they pay on deposits. In this way, the inversion undercuts bank profits and reinforces the pressure on the economy. Yield-curve inversions are often one of the more predictive indicators of recessions.
U.S. and international political disruption
Geopolitical uncertainties—such as the U.S. and China trade dispute, the growing U.S. political divide, Brexit, and tensions in the Middle East and North Korea—may disrupt the global economy. Sustained geopolitical uncertainty could continue to dampen sentiment, potentially triggering a sustained economic downturn.
High-yield corporate debt spreads
Increasingly higher yields for non-investment-grade bonds relative to U.S. Treasury securities of comparable maturities may signal stress for lower-quality debt. Currently, only a few sectors of the high-yield corporate market—particularly the Energy sector—are experiencing these higher spreads.
During this expansion, absolute debt levels have risen, yet signs of stress are not evident at this time. Household debt/GDP ratios remain elevated compared with historical levels but are lower than they were before the Great Recession.
Federal Reserve (Fed) policy
We see a significant risk for two potential policy mistakes. First, the Fed may fail to cut interest rates sufficiently for a slowing economy that faces heightened political uncertainty. Second, there is a risk that the Fed exhausts effective monetary tools to fight the next recession.
The Conference Board Leading Economic Index® (LEI)
This index of 10 market and economic indicators can be used as a barometer of early signals of slowing growth. The LEI is slowing, as it did twice earlier in this expansion (in 2012-2013 and 2016). However, during those earlier slowdowns, the headwinds were less concerning to us than they are today. This suggests the risk of a recession is rising, along with the potential for a bear market over the next 12 to 24 months.
Why this cycle is different
While the current recovery is the longest on record, the average pace of growth during this recovery has been 2.3%—significantly lower than the 4.0% average gross domestic product (GDP) growth rate the U.S. experienced during the past six recoveries.
Four ways investors can position portfolios for the next downturn
For more insights, including growth-oriented strategies and considerations for those nearing retirement, download the full report.
Diversify to help mitigate risks.
Diversification can allow investors to participate in late-cycle upswings and mitigate global market volatility. Consider broadening exposure to alternative investments, including hedge funds and private capital.*
Manage cash during periods of volatility.
Instead of holding large quantities of cash, deploy it selectively as markets pull back.
This long economic expansion may have created a much higher equity exposure than originally desired in many portfolios. Rebalancing back to strategic targets can help prepare a portfolio for a market correction or economic downturn.
Know what you own.
Investor sentiment can outpace fundamental value late in a cycle. If expected returns look too good to be true, they probably are. Know what you own also means accounting for overlapping exposures or concentration risk. For example, some growth-oriented equity funds were not as diversified as they seemed in the late 1990s because growth-oriented equities as a group became overvalued.
* Alternative investments, such as hedge funds and private capital are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
Find more in the full report
The full “How Bull Markets End” report from Wells Fargo Investment Institute includes:
Additional specific strategies for
Investors nearing retirement
More details of warning signs that suggest a bull market top may be near
A look at managing stocks through market volatility
For additional insights and market commentary, visit our website. For assistance with your investment planning or to discuss the points in this report, please talk to your investment professional.