Welcome to the “Late Comers” and beware of human nature

Stocks across the globe have risen significantly over the past five years reaching historic highs as of this writing. Though these past five years have not been for the faint of heart — a period of dramatic market volatility, geopolitics and dysfunctional domestic policy — we feel very fortunate that we have been effectively participating in this profitable era. The questions investors must ask themselves today remain the same: “How much longer can stocks continue their upward ascent?” and “What can we do in the event of a market decline beyond a normal correction, i.e. 2008?”

Periods of multi-year rising stock prices (“bull” markets) are fueled by a growing economy/corporate profit and also by investor confidence. This bull market has been no exception. Bull markets also — unfortunately — have a life expectancy. Historically, economic expansions which drive profit growth and stock prices, last 7-9 years on average and end in recession. Recessions are the ultimate foe of the bull market, causing corporate profits to tumble — if not vanish all together. The effect on stock prices is significant in each recessionary case with average decline in stock prices in the 35% range — what we call a “bear” market. During the last two recessions (2000 and 2008) we witnessed two declines of greater than 50%. That said, our research suggests that a recession is unlikely over the next 18 months and that this bull market still has time to run. A few data points that are worth noting which support this case: an economic expansion that is aging (5+ years) but not geriatric, reasonable stock prices relative to earnings (P/E ratios), low interest rates, and a historically low percentage of household and institutional stock ownership.

Our research suggests that we are in the last third of this bull market. This phase is often characterized by a further and significant rise in stock prices — often fueled by investors who previously were underinvested. As you may recall, most investors did not believe in an economic or stock market recovery back in 2009 (fortunately we did) and consequently most investors did not participate in the market’s rise. Now, as in past bull markets, those investors who were previously pessimistic (we shall call them the “late comers”), are finally starting to buy stocks. During this period, we should witness the percentage of stock ownership increase from its current historic lows to a more normalized degree — at which point we should become much more cautious.

As the global markets go higher, with corrections along the way, we must reverse what our human nature tends to make us want to do. By that we mean as the “late comers” join the party, we should carefully, gradually and over time begin to exit. By doing so, we will protect ourselves from the inevitable decline that awaits us all somewhere down the road. The easiest way to do this is to reduce the percentage of your stock holdings and do so in the sectors that would be most negatively affected by a recession. If you were with us in 2006, you may recall a similar message. Again, this is not a call to action at this point, but a reminder of our strategic plan as the bull market ages.

In the meantime, we are very aware that the current economic expansion and global bull market could be de-railed earlier than expected. Therefore, we continue to manage the risk of your portfolio through your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders on those positions that would be most vulnerable to an economic recession.

This is a great bull market and we believe that it has room to run. We thank you for your confidence in our team during this era and look forward to monitoring the “bull’s” progress. If there has been any change in your financial situation or you would like to review your portfolio please let us know.

Sincerely,

Your Team at Main Street Research