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Reasons to Remain in the Stock Market

| November 16, 2017

The stock market has recently made new highs, and investors have to wonder – given the prolonged and consistent rally – if now is the right time to reduce exposure. As always, it makes sense to take a step back and consider the evidence in order to determine the proper course.

In August, I mentioned that three common sources of financial disturbance – fiscal policy contractions, monetary policy tightening, and financial crises – all appeared to be in check at the moment. Generally speaking, not much has changed over the past few months. The odds of a December rate hike by the Fed have gone up and the yield curve has flattened, but the big picture remains the same. If anything, the stock market’s strong performance over the summer should be a source of comfort for investors. Historically, the period from May through October is usually the weakest stretch of the year for equity markets (which gives rise to the expression “sell in May and go away”). However, as pointed out by The Fat Pitch, when the S&P 500 manages to go up by 5% or more during this period, the market extends those gains over the following six months around 90% of the time. Since the S&P 500 was up over 8% from May through October, this suggests that the market may be poised for further advances.

In terms of economic fundamentals, a useful tool for reviewing market-related worries is Citigroup’s Bear Market Checklist. This is a list of 18 factors that examine global equity valuations, the yield curve, investor sentiment, corporate behavior, profitability, and balance sheets, to assess the likelihood of a serious financial downturn. This list has a pretty good record for highlighting potentially treacherous investing environments: In 2000, 17 of the measures suggested the market rally was unsustainable; in 2007, 13 factors were sounding alarm bells. As of the end of October, only 3 of the 18 factors are indicating that investors should be concerned. This provides further confirmation that the market isn’t at a precipice.

While no market cycle is ever exactly alike, market peaks are normally accompanied by investor euphoria that leads to an exhaustive market rally. Look at the bull market during the 1990’s relative to the current progression:

Note that over the last two years of the rally in the 1990’s, the market advanced close to 40%. This is worth remembering because investors need to consider that, even though there has already been a prolonged rally, there may be substantial upside remaining before the eventual peak.

Rallies don’t die of old age; a change in the economic or macro climate is required. While some of the events that cause markets to fall may only be understood or appreciated in hindsight (that is, after the market has already collapsed), there are many avenues for examining the factors that can give us evidence-based warning signs. Currently, there appear to be few such alarms. This doesn’t mean that the market is set for smooth sailing. There have been four 10% corrections during this current bull market and further volatility should be expected, but until there is a fundamental change in the investing landscape, investors should likely maintain their base equity exposures.

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