Here’s how bruised bears should approach this resilient stock market

bear-market-bearMy Comments: I’m facing increased criticism for preaching woe and gloom. In spite of a 24 month rain dance to herald the start of a storm, the sky is still clear, if a little overcast. Maybe it is different this time.

That being said, it’s time to stop with the woe and gloom and focus instead on steps to take advantage of the situation. As a friend pointed out yesterday, this stuff cycles and, yes, there will come a bad downturn, and you will be declared right. Meantime, you miss out on all the good stuff and end up stiffing your clients.

So… how do we set ourselves up to be successful? Here’s a start.

by Anora Mahmudova | Published: Sept 27, 2016

It is perfectly fine to be pessimistic about future stock market returns, as long as you’re prepared to think outside the box when it comes to seeking out safe investments, analysts said.

There is no shortage of scary charts and lousy fundamentals that point to equities being risky. But they rarely, if ever, can be used to pinpoint a market top. Indeed, bold bearish calls continue to get rebuffed in this long-running bull market.

Recall that in early January, RBS analysts made their highly publicized call to “sell everything except high quality bonds”.

Barely a month later, when the S&P 500 SPX, +0.64%  dropped to multiyear lows to mark a third correction in less than two years, it seemed the call would be vindicated. But after nine months, it is apparent that heeding it would have been costly as markets soon rebounded and then rallied to records.

Valuations are above historical averages and earnings growth has deteriorated over the past two years—all suggesting that, in the long term, returns are going to be low.

Wouter Sturkenboom, senior investment strategist at Russell Investments, said the current environment has been among the most trying he can recall for market bears.

“Normally, if you feel bearish about the stock market you would be looking for safe bets but right now, all the traditional safe bets are no longer safe,” Sturkenboom said, in an interview.

Even bonds, which tend to rally when things get gloomy, aren’t a reliable wager.

“Bonds are overvalued, which makes exposure to duration risky if inflation rises even by a bit,” he said.

Duration is a measure of the sensitivity of a bond’s price to a change in interest rates. Bonds with higher duration carry more risk.

The first step investors should take now is to accept that future returns will be low, said Michael Batnick, director of research at Ritholtz Wealth Management.

“Stocks are expensive on every metric you take and that means that future returns will be lower. Investors should simply accept it and act accordingly, which means saving more,” he said in an interview..

“The idea you can take lower returns and turn them to get higher returns by timing is ruinous for average investors. It doesn’t work for the vast majority of investors. Even if you knew with precision how much earnings will be next year, you won’t know what multiple millions of investors are going to pay,” he said.

While pessimism about returns is pervasive, there are still ways to invest and build wealth.

Both Batnick and Sturkenboom advocate adding assets with lower valuations while trimming exposure to expensive U.S. large-cap equities.

“For investors looking for safety bets, they should think outside of the box. Safety now comes in cheap valuations and there are several assets that could fit the bill out there,” Sturkenboom said.

Among assets that Sturkenboom prefers are Spanish and German real-estate investment trusts, gold ETFs, Treasury inflation-protected securities, or TIPS, and cash.

While cash gives investors the option to swoop in and sweep up bargains when the market tanks, it requires patience as big drawdowns are rare events, Sturkenboom said.

“Cash is good if you are tracking markets and can deploy it quickly. The past three years have been disappointing for those who held cash and were unable to buy at corrections, because they were very short-lived,” he said.

“But in the current environment it is still worth it to keep cash for the eventual 30%-40% drawdown, the likelihood of which is pretty high over the next three years,” he said.

Batnick is a fan of rules-based planning: “You have to have a plan and stick to it. Allocate to markets that are cheap on relative and absolute terms, but don’t try to wing it,” he said.

“Building wealth through investing in the stock market requires a lot of pain. There will be big drawdowns. But more money has been lost by trying to avoid drawdowns than by staying invested,” Batnick said.

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