• Wealth Management

Wringing Out the Market’s Excesses

Stocks are likely to remain volatile near-term, but this is a good time to look for high-quality, defensive names to add once markets stabilize.

The S&P 500 is now officially in correction territory—off more than 10% from its peak just four weeks ago. I wrote recently that investors shouldn’t buy former market leaders after a dip expecting them to quickly rebound.

However, now that the market’s downward move seems likely to end soon, this could be a good time to bargain hunt among high quality stocks with defensive characteristics.

Below are three reasons I don’t expect the October sell-off to last much longer.

  • Excesses are being wrung out. The S&P is down 10%, but the average stock is down 20%. Market leaders in tech and consumer discretionary have been hard hit. In the past month, those sectors have generated returns roughly in line with the broader market after years of dramatic outperformance. Valuations generally are more reasonable. The price-earnings ratio of the S&P is now 16, near the average of the last 40 years.
  • Investors seem less complacent about the risks to global economic growth in 2019. Stocks in defensive sectors like utilities, consumer staples and energy are now performing better than stocks tied to the economic cycle, such as tech and consumer discretionary names. Assets like gold, the dollar and the Japanese yen, often seen as more stable investments, have strengthened.
  • Indicators of investor fear are also rising, which is a sign that negative sentiment may be getting flushed out, an event Wall Street strategists call capitulation. Signals from the options market, portfolio hedging activity and investor surveys all suggest that the market is reaching an oversold state.

I don’t see a lot of additional downside ahead, but I am still cautious. I’ve taken note that credit markets (mainly corporate bonds), have remained resilient. While some investors take comfort in that fact, I worry that liquidity conditions could get worse next year. I think a repricing of corporate credit could be the last shoe to drop before the sell-off is complete.

Bottom Line: The current correction has done more damage beneath the surface than the major indices suggest. I think the correction is likely to end soon, but investors should wait for this period of volatility to subside to get more invested.

For now, investors with cash on hand may want to look for bargains among high-quality stocks with defensive characteristics. The hallmarks are low debt, growing dividends and reasonable valuations.