SunTrust Advisory Services, Inc. Market Perspective The Pain Trade Keith Lerner, CFA, CMT Director, Chief Market Strategist March 6, 2017
The Pain Trade Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves. Peter Lynch Our 2017 outlook advised investors to lean bullish, while recognizing the range of potential outcomes widens given policy dependencies (upside and downside risks). Thus far, the three primary supports for our positive equity outlook appear intact: 1) a global reset is underway as underlying economic trends are improving; 2) profit trends are rising; and 3) positive sentiment is leading to the strongest retail stock fund inflows in several years. Still, the strength and persistency of the current up leg the S&P 500 has not had a 1% down day since October 2016 and is now in the longest stretch of this bull market without so much as a 5% pullback has been impressive but also painful for those underinvested. At this point, the market appears extended near term and is likely to take a breather; however, the intermediate outlook points higher. Thus, we would stick with the positive trend and worry less about trying to time the next pullback perfectly. For investors on the sidelines, we do not believe it is too late to put some money to work, though we generally recommend a dollar cost averaging approach, where a set amount of money is added on a regular basis (and potentially increased on pullbacks). This should help to relieve the angst of putting fresh money to work at record market highs. From an allocation perspective, we maintain our stock bias relative to bonds. Within equities, we keep our long-standing US tilt and cyclical sector bias. We are, though, seeing improvement in international markets, where valuations, unlike in the US, remain below cycle highs and profits are turning higher. Specifically, we remain bullish on Japan, we would view pullbacks in Europe related to election uncertainties as tactical opportunities and are constructive on emerging markets. Although we recommend an underweight to fixed income, highquality bonds should be looked to as a shock absorber during bouts of stock market weakness. Indeed, even though the recent period in the stock market has been tranquil, there has only been one year since 1980 that didn t see at least one 5% setback. Regular investing does not assure a profit or protect against a loss in declining markets. Dollar Cost Averaging involves continuous investments in securities regardless of fluctuating price levels. Investors should consider their financial ability to continue purchases through periods of low price levels. 2
'50 '51 '54 '55 '61 '67 '71 '72 '75 '83 '85 '86 '87 '88 '91 '93 '95 '96 '97 '98 '04 '06 '11 '12 '13 Average Strong Starts to Years Tend to be a Good Market Omen When January and February have both seen positive returns, the S&P 500 has tacked on additional gains by year end in 23 of 25 instances (average gain = 12%). Keep in mind, though, the average pullback from a high at any given point was 9.9%. This data suggests the underlying market trend points higher, but investors should expect bumps along the way. 50. S&P 500 Returns for the Rest of the Year When January and February Were Both Positive 40. 38% Returns (Mar through Dec) Maximum Intra-year Pullback 30. 20. 10. 19% 9% 24% 17% 13% 11% 11% 11% 11% 6% 7% 4% 14% 5% 26% 16% 23% 17% 6% 11% 4% 22% 12% 0. -10. -20. -13% -5% -9.9% -30. -40. Source: Strategas 3
US Stock Market is Now Most Overbought Since 1996 The Relative Strength Index (RSI) for the S&P 500, a measure of price momentum, last week reached 81%, its highest level in over 20 years (the indicator ranges from to 10). This indicator suggests the market is getting stretched short term and is due for a breather. The good news is after past signals, stocks still averaged a 9% gain over the next 12 months. 2500 2200 1900 1600 1300 1000 10 8 6 4 2 S&P 500 Relative Strength Index S&P 500 Average Returns After RSI >8* 1 3 6 12 month months months months later later later later Average Gain 0.9% 2. 3.1% 9.3% % Periods Positive 6 66% 69% 76% 2012 2013 2014 2015 2016 2017 Data Source: FactSet; SunTrust IAG; Study done from 1928 to current (initial signal used above 8). The RSI is a momentum indictor that measures the speed and change of price movements over a 14-day period. It is rare to see this metric move above 8. 4
Longest Period of Bull Market Without 5% Pullback While we continue to lean bullish, we also recognize equities have gone the longest period of this bull market without so much as a 5% pullback. There have been 15 such pullbacks since this bull market began in 2009, and we expect to see a few this year as well. As long as economic and profit trends remain favorable, we view pullbacks as buying opportunities. S&P 500: Days Between 5%-plus Pullbacks Since 2009 231 182 187 205 227 218 247 74 101 81 74 105 70 118 44 Mar-09 Jul-09 Oct-09 Feb-10 Jul-10 Mar-11 Oct-11 Jun-12 Nov-12 Jun-13 Feb-14 Oct-14 Aug-15 Feb-16 Jun-16 Source: FactSet, SunTrust IAG 5
Percentage of Bullish Advisors at Cycle High The latest Investors Intelligence Sentiment Index, shows bulls at 63% versus 16.5% bears, which is the widest spread of this cycle. Stocks have tended to pause short term after reaching these levels over the past few years. 2400 S&P 500 2000 1600 1200 2013 2014 2015 2016 2017 5 % Bulls minus Bears 4 3 2 1-1 -2 2013 2014 2015 2016 2017 Data Source: Investors Intelligence, SunTrust PWM 6
Equity Fund Inflows Should Remain Supportive Prior to the election, stock mutual funds saw the greatest outflows since the financial crisis. However, since November retail investors have added nearly $100 billion into equities. There is scope for this to continue, given since the financial crisis investors have poured in about 2.5x more money into bonds relative to stocks. $40 $30 Monthly Equity Fund Flows (Mutual Funds & ETFs, Billions) $20 $10 $- $(10) $(20) $(30) Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Data Source: Haver, ICI 7
Stocks Can Rise Alongside Fed Rate Hikes During the last interest rate tightening cycle, which occurred from 2004 to 2006, the Fed raised short-term rates 17 straight times (from 1. to 5.25%); stocks still grinded higher with a total return for the S&P 500 of about 15%. A risk to the market is if the Fed raises rates much more aggressively than current expectations or economic data falters; this is not our base case but something to monitor. We continue to expect two to three rate hikes this year. 2500 2000 S&P 500 1500 1000 500 '02 '04 '06 '08 '10 '12 '14 '16 9% 8% 7% Federal Funds Rate 6% 5% 4% 3% 2% 1% '02 '04 '06 '08 '10 '12 '14 '16 Data Source: Haver, SunTrust IAG 8
Keeping a Stock Bias Relative to Bonds Stock valuations are on the high side of historical norms; this suggests longer-term returns will be below average. Nonetheless, in a world where there is a dearth of cheap assets, equities still appear attractive on a relative basis. Average S&P 500 Trailing P/E by Decade Average Bond P/E by Decade (100/10-Year Treasury Yield ~2.5%) 18.1 19.5 20.1 19.6 33.5 40 12.5 11.7 21.1 13.6 9.9 15.5 1960s 1970s 1980s 1990s 2000s Current 1960s 1970s 1980s 1990s 2000s Current Source: FactSet, Strategas, SunTrust IAG 9
Maintain US Bias but International Opportunities Remain We keep our US equity bias. However, unlike in the US, international valuations are below cycle highs. We remain positive on Japan, which is cheap, is cash rich, and has political stability. Tactical opportunities in Europe are likely to present themselves around the elections this year. Emerging Markets on the back of cheap valuations, solid economic trends, and improving earnings are also doing well despite trade protection and rising US dollar concerns. 19 17 15 13 11 9 7 Forward P/E* US Non-US Developed Markets Emerging Markets 5 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Data Source: FactSet, MSCI, SunTrust IAG; *A Price-to-Earnings Ratio is a metric used to value the stock market and takes into account the current price of an index or stock relative to its earnings, in this case projected 12-month profits. US represented by S&P 500; Non-US Developed Markets represented by MSCI EAFE; Emerging Markets represented by MSCI EM. International investments are subject to special risks, such as political unrest, economic instability, and currency fluctuations. 10
International Profit Trends Continue to Improve Earnings trends in international markets which have negatively weighed on market performance in recent years are turning higher on better economic growth, policy support, and more competitive currencies. 1 5% -5% Non-US Developed International Markets Year-over-Year EPS Growth -1 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16 Feb-17 Emerging Markets Year-over-Year EPS Growth 15% 1 5% -5% -1-15% -2 Feb-12 Feb-13 Feb-14 Feb-15 Feb-16 Feb-17 Source: FactSet, SunTrust IAG; Non-US Developed Markets represented by MSCI EAFE; Emerging Markets represented by MSCI EM. 11
Bonds Should Help Buffer Downside Market Shocks We continue to recommend a stock bias, however; given the potential for wider market outcomes this year, high-quality bonds should provide ballast for portfolios; intermediate-government bonds have risen in 22 of the 24 years that saw stocks decline. Further, a bad year in the bond market has historically been nothing like a bad year in stocks. Bonds Returns in Years When Stocks Were Down 2 1-1 -2 6% 7% -8% -2% 9% 9% -8% -1% 2% 5% 3% 1% 1% -1-12% -8% 8% 6% 3% 5% 5% 6% -1% -1% -11% -9% -1-9% -15% 9% 1 13% 13% 13% 8% 1% -7% -5% -3% -9% -12% US Intermediate- Government Bonds S&P 500-3 -25% -26% -22% -4-5 -35% -37% -43% '29 '30 '31 '32 '34 '37 '39 '40 '41 '46 '53 '57 '62 '66 '69 '73 '74 '77 '81 '90 '00 '01 '02 '08 Source: Morningstar; Bond index = Ibbotson Intermediate-Government Bond Index; Stocks represented by S&P 500 12
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The bond chosen each year is the shortest non-callable bond with a maturity between 5 and 6 years, and it is held for the calendar year. S&P 500 Index is comprised of 500 widely-held securities considered to be representative of the stock market in general. MSCI EAFE index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. MSCI EM index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The Investors Intelligence Sentiment index is a weekly survey of newsletter writers and measures whether participants are bullish on the stock market outlook. At extremes, it is often looked to as a contrarian indicator. CN2017-0710EXP12-2018 13