Dances with Bulls… & Bears
Late Cycle Opportunities and Risk
As we enter the second half of the year global stock indexes have exceeded almost every strategist’s expectations. This powerful advance has just slightly erased the entire steep decline of 2018. It is unusual since it hasn’t been based on any strong underlying themes. In fact stocks have rallied into declining economic growth and corporate earnings, a tariff war, and a Federal Reserve which has become concerned about the potential for a recession. So what gives? Is the stock market vulnerable? Is there more upside left? We would suggest a little of both.
During the later stages of an economic expansion stocks often stage a “super rally” before running into trouble. Investors who recall 1999’s astonishing advance just before the 2000-01 bear market (-50% for indexes) can attest to this phenomena. Like today’s rally, ‘99 came after a significant warning decline in ‘98 (Russian debt crisis). That decline was quite similar to the mini bear market of last fall. Late stage rallies like today or others in history can go on longer and higher than investors expect – usually on less than perfect economic and earnings growth – and can be tricky. Our human behavior doesn’t want to miss a stitch of any upside, but we also don’t want to be vulnerable to a significant decline. There are several ways to play this scenario.
So far our strategy for this late stage rally has been to have less stock exposure. Sacrificing some upside to mitigate risk and adding to stocks only on market corrections and or when we find unique situations. At this point your portfolio is 2/3rds invested as opposed to 100%, but given that the Federal Reserve may lower rates to “save the market” what if the late stage rally lasts another year?? Should we be more invested? Yes, but only during market pullbacks.
As long as we add stock exposure during market corrections, as we did in May, we are assured of taking less risk and getting your portfolio closer to index-like returns over time. Each time indexes trade down your portfolio holds up better and our opportunity to add stock presents itself. It’s a “dance” of sorts and we know this process can test the patience of the most aggressive, growth oriented investor, but historically it has worked for our firm. When we say worked, we mean gaining return while managing risk.
Those investors who have been with us through a number of market cycles have firsthand experience that our process works and has allowed us to deliver long term performance with less risk (better standard deviation) but it does require patience. That’s why we encourage investors to measure our performance process in years, not months.
Over the next few weeks we will be in the thick of earnings reports for the second quarter. We believe these earnings will be less than expected and coupled with continually weaker economic data and tariff pressure. Investors should expect a normal market pullback from current levels and we will use such a pullback as another opportunity to add stock exposure.
We have and can continue to gain profitability in this late stage bull market, but it is a riskier environment and one that requires us to be aware of downside risk. Keep in mind that should stock prices begin to fall more than normal we are willing to reverse our “dance” pattern, reduce stock and sector exposure, and continue to have stop loss orders to fend off catastrophic loss.
We hope this short update is helpful as we head straight into earnings reporting season and provides clarity on our opportunistic view of the markets.
If you have experienced any changes in your financial circumstances or would like to review your portfolio please let us know.
Your Team at Main Street Research.
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