The behavior of global stock markets in recent quarters, weeks and days is out of character for what we consider a healthy bull market. Each time market indexes try to recover to the highs of last summer, they fail to do so. Meanwhile, many sectors of the market have declined significantly compared to the market indexes during this period, particularly those tied to economic growth. The question investors should be asking is whether we have entered the beginning of a bear market? If so, what can we do to mitigate risk? Or is this just a temporary lull that will pass with time?

The bull market that began for global equities in 2009 appears to have stalled and there are a number of logical reasons, most importantly a slowing global economy. Over time, stock markets are linked to underlying economic growth. A growing, expansionary economy fuels higher consumer and corporate spending and corporate profits, thereby lifting stock prices. A slowing or receding economy removes the support for equity prices to continue their rise. When a recession comes into play, stock prices are unable to sustain their high valuations — given the lack of profit growth — and must be adjusted downward to reflect values closer to reality. At this point it is difficult to make a conclusive argument that a bear market is definitely “in play,” however the evidence continues to mount in the bear’s favor. As we survey the market by sector, it is obvious that many parts of the market have been in a declining trend beyond normal for some time — specifically, energy, materials, and industrial stocks. Fortunately, we have been either very underweight or not invested in these sectors over the past few quarters. More recently, there is beginning to be weakness in technology, financial and consumer discretionary stocks. All said, out of the 10 sectors of the global economy, only three are acting well: consumer staples, healthcare and utilities — the areas where your portfolio is over-weighted and which are somewhat immune to bear markets and recessions. Should stock indexes turn down much further than the recent lows — which would likely be on the heels of more negative economic data — investors should expect a further decline in the already unhealthy sectors and overall stock indexes. Such a move downward would signal that a true bear market is upon us and would cause us to take an even more defensive posture further mitigating your risk.

If we enter a bear market in stocks, how bad and how long? Here is the good news about the bad news! Bear markets are not typically long affairs, usually 6-12 months in duration, and stock indexes in general decline on average 25-50% during these periods. If an investor were fully invested in the most vulnerable sectors — which you are not — this period could be quite painful. In our opinion, should we enter a true bear market, it will likely be gentler in decline and possibly brief compared to those in the past. We reach this conclusion based on a number of factors, the most important being that stock prices were not at excessive levels to begin with, and that corporate inventories are quite lean compared to previous recessions. In any case, we believe that taking a defensive stance would be best to mitigate the risk of a more significant decline.

It is possible that this lull might pass and that the bull market resumes from these levels. However, this would only occur if we get some powerful and positive data about the global economy’s growth rate. It is also possible that the Federal Reserve could announce a reversal of their current dedication to raising interest rates, and instead consider lowering them. This bull market has thrived on Fed liquidity and such a change in policy may bring the bull roaring back.

As we continue to plod through this tougher environment, it is important to realize that outside of your stock exposure, your preferred shares, REITs, utilities, bonds and cash continue to serve as a solid anchor.

In the absence of further data, we will continue to manage your portfolio’s risk through your asset allocation, sector management and the use of carefully placed stop loss orders. In the meantime, we will be watching all data points closely and be prepared for any changes that may be necessary.

We hope this short update finds you well. If you have experienced any significant changes in your financial situation or would like to discuss your portfolio please let us know. All of us wish you a great weekend.

Sincerely,
Your Team at Main Street Research