Throughout the second half of summer, JNBA’s Investment Committee warned that divergences between U.S. and foreign markets had elevated risks for the possibility of a broad-based market pullback. While U.S. equities ignored these signals through September, they caught up in a hurry in October with the large cap S&P 500 dropping 7% while the small cap Russell 2000 lost 11% for the month.
As a result, the question on many investors’ minds is, “Will an October to forget lead to a November to remember?” Seasonality and the market being able to put the uncertainty of mid-term elections behind it would say that markets could rally somewhat between now and year’s end. Our expectation is that the market should rebound from the current oversold conditions and investor pessimism that, perhaps in the short run, has become too negatively lopsided providing some fuel for what has been deemed the “Santa Claus” rally.
However, our overall stance is still to lean towards being cautious in rebalancing portfolios. Over the past few years, we have seen several market sell-offs in the 10% range that within a quarter or two have managed to rally back to new highs. What is more concerning about the current sell-off is that foreign stocks and emerging market equities have been trending lower for several quarters – not just a short-term panic to oversold conditions. In addition, the U.S. market has begun to correlate with the rest of the world to where now 80% of global markets are within 5% of one-year lows and 0% of global markets are within 5% of one-year highs.
Broad-based weakness has put 40% of “bear market watch indicators” pointing to additional vulnerability (chart below). Bear market watch indicators are a variety of trend, sentiment, and valuation indicators that have historically helped to predict the market’s ability to gather momentum to the downside. Over the past 30 years, when half or more of the indicators are negative, the market’s median decline has been just over 20%. On the verge of indicators warning of a possible prolonged pullback (versus this being a quick 5-10% drop), our Investment Committee continues to view the market through a cautious lens. (The below chart highlights in red where bear market watch indicators have reached 50% while the bottom clip shows the current 40% reading.)
In order for us to become more constructive on equities, signs of broad-based bottoming for global markets would need to occur. The U.S. completely decoupled from the rest of the world in May through September, which generally has not been a healthy condition for global markets. At present, setting the short-term rebound following mid-term elections aside, all major global markets are generally moving lower together. Historically, these are conditions that have often led to larger declines, which has us at present, cautious in our positioning. However, we are not yet at our most defensive target allocations as various aspects of the U.S. economy and earnings landscape have remained at fairly healthy levels.
For the market to make a sustained move higher we would likely need to see successful re-tests of the recent lows for global equities followed by broad-based rallying with healthy breadth and participation. Until that point, we expect the choppiness we’ve seen of late continue with bouts of downside volatility followed by short and brief rebounds. The bottom line is that our Investment Committee believes now is not the time to be over-exposed to equities and to aim for exposures that are slightly below “neutral” positioning.
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