• Wealth Management

Is It Time to Worry?

As the S&P 500 climbs to all-time highs, so has investor concern about a downturn. Should investors be embracing the bull—or is it time to play it safe?

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There has been an extraordinary amount of concern about the next downturn. In fact, since the beginning of this bull market in early 2009, more has been written about the potential risk than the reward. 

I imagine this is to be expected after two 50% corrections in U.S. equities that left virtually every investor severely damaged and scarred. What it really did was prevent people from embracing one of the best cyclical bull markets of our lifetime—in both stocks and bonds.

In January of this year, we provocatively titled our year-ahead outlook “Are You Ready for Euphoria?” because we thought investors were finally ready to embrace this bull market. From a price standpoint, we can say “so far, so good.” Global equity markets are annualizing north of 25% for the year to date, with the riskiest markets leading the way. The S&P 500 Index is annualizing at just 19% which puts us right on track for our target of 2,700 by year-end—a target we at the Global Investment Committee maintain in the face of continued skepticism.

Downturn Worries

Investors and the media have yet to embrace this bull market and until they do, we are likely to keep climbing the wall of worry. Now, the latest worry is investor complacency. Specifically, there is great concern that low volatility in the markets is bound to reverse, that investors are ignoring the real concerns about North Korea, a U.S. debt ceiling that expires this fall, an unpredictable president and Washington gridlock. 

Our view is that the equity markets have low volatility because we have been experiencing low volatility in the things that drive equity prices—interest rates, economic data and corporate earnings. Therefore, low volatility is not the result of investor complacency but rather reflects a very good investment environment that should be embraced. 

Last week, that view was challenged by escalating concerns about a potential military conflict with North Korea. Investors have now reached one of their most risk averse postures in the past several years—a time when we’ve had some rather scary events like China’s devaluation, Brexit and a contentious U.S. election.

To further our point about investors’ lack of willingness to embrace this bull market, below is a series of charts to illustrate this point.

First, our proprietary U.S. Equity Risk Indicator combines both sentiment and positioning data. As you can see, we are in a neutral zone after reaching a more exuberant range at the end of last year following the US election. Since then, investors have become more skeptical about policy change and hence less bullish about U.S. equity markets. 

 

Investors Are Becoming Increasingly Skeptical in 2017

Source: Morgan Stanley & Co. Research as of Aug. 11, 2017

Next, we break down positioning from sentiment data and discover a widening divergence between the two, with investor positioning more negative than sentiment. This looks similar to last fall’s pattern going into the election season, which turned out to be a positive set-up for a strong finish into year-end. We think today’s divergence is the result of investor anxiety about normal seasonal weakness in a year that has yet to see more than a three percent correction. To us, this means it’s going to be difficult to sell-off significantly when investors are already set up for it. 

 

Investor Positioning More Negative Than Sentiment

Source: Morgan Stanley & Co. Research, Morgan Stanley Prime Brokerage, Haver Analytics, Bloomberg, FactSet as of July 31, 2017

This next chart simply shows how unloved this bull market has been by individual investors. Since 2007, U.S. equity mutual funds and exchange traded funds have suffered net outflows to the tune of $250 billion while close to $1.6 trillion have flowed into bond funds—wow.

 

Cumulative Net Flows 2007-2017 (in Billions)

Source: Haver Analytics and ICI as of July 31, 2017

Truth be told, the best returns of this cycle are likely behind us. However, there should still be good returns to be had before the end of this cyclical bull market. Fretting about minor corrections is exactly the kind of behavior that has prevented the average investor from fully participating during the past eight years. The concerns lately have been circumstantial for the most part, lacking in fundamental merit and centering on speculation about what bad things could happen. 

In contrast, our work at Morgan Stanley has been focused more on what we can analyze and predict. Specifically, we’re concerned with economic data and other macro factors that tend to lead the earnings cycle. The biggest benefit of such focus is that it keeps us out of the political and geopolitical arena—the areas which, for some investors, have been a tough wall of worry to climb.

Note: This article first appeared in the August 2017 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

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