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Major U.S. stock indices ended the third quarter of the year at, or near, all time peaks.  

Oct 2018
SQRMarketing

Major U.S. stock indices ended the third quarter of the year at, or near, all time peaks.   What is good for the economy has also been good for stock prices.   While the backdrop for stocks remains largely positive, we are in an aging bull market expansion.  Since the trough in March 2009 the S&P 500 index (excluding dividends) has risen 331% through September 2018.  That is a lengthy and impressive run, albeit supported by many unconventional stimulus measures, including the recent tax overhaul.   But what matters most is earnings, and earnings for the S&P 500 increased 26% over the first half of 2018.  Current consensus for third quarter earnings is 19%, still very strong.  Related to earnings is the valuation of stock prices – the multiple that investors will pay for expected earnings.   At the close of September, the S&P 500 was valued at 16.8x expected earnings.  That is only slightly above the 25 year average of 16.1x as the above-mentioned earnings growth has helped to bring valuations down.  So while stocks are not cheap, they do not look especially expensive either.

So how should investors navigate a late-stage bull market in stocks?   We are guided by the following principles:

  1. Maintain an appropriately balanced exposure to stocks by reducing oversized allocations to equities resulting from stock price appreciation. While reducing equities normally entails taking capital gains, re-balancing the asset allocation is a forced discipline that has served our clients well in the past.
  2. Reserve adequate liquidity to meet distribution needs for at least one year. This liquidity can be in cash or short-term bond funds.   Maintaining cash reserves will reduce the overall price volatility in the portfolio, and add flexibility to meet needs without having to sell securities at inopportune times.
  3. Resist the temptation to time the market. Equity investment risk is best managed with a long-term holding period in mind, as stocks tend to rise over time but can be volatile in the short-term.  We do not expect to time the market top, just as we did not attempt to forecast the bottom in 2009.  Staying invested, with the amount of equity capital that reflects a client’s risk tolerance, is a better approach.
  4. Have some dry powder, and be selective. Our focus is on identifying investments where earnings confidence is high, management has a strong track record, and growth can endure even if the economy slows.  Having cash to add to positions helps with this process.
  5. Pare back positions that have become outsized holdings in the portfolio. Doing so is always hard to do in a rising market.  But the aphorism – “you will never go broke taking profits” – has some truth.   Even the bluest of the blue chip stocks hit air pockets along the way, so paring back overweight positions is a way to protect gains and reduce risk at the individual stock level.
  6. Utilize Structured Notes where appropriate. Issued by banks, these notes allow investors to participate, sometimes in a leveraged fashion, in any market increase while at the same time provide a downside “buffer” ranging from 15-20%.
  7. Recognize that corrections are a normal part of market cycles. The market downturn of 2008-2009 still looms large in investors’ collective memories because it was extraordinarily severe. Market corrections of a smaller magnitude are much more common – see the accompanying chart showing there have been seven corrections of at least 10% throughout the current nine year expansion. In each instance when panic selling ensues, it has been wrong to assume that a redux of the 2008-2009 financial calamity is upon us. Corrections over the course of a market cycle serve to flush out imbalances in the market; in that case we should welcome corrections because without them these imbalances tend to build up over many years, laying the groundwork for a more severe downturn.

While we may not be able to predict the severity or timing of the next market correction, we can prepare by taking deliberate and disciplined action along the way. The seven principles outlined above are examples of the actions we are taking.

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