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A Healthy Near-Term Pullback in U.S. Stocks Could Afford Better Investment Opportunity

It has been a stunning reversal of fortunes for U.S. stocks. The V-shaped recovery since the near-bear market in last year’s fourth quarter has put the major indexes back to or near record. But has it been too far, too fast?

Late-last year the stock pendulum arguably swung too far toward pricing in an imminent recession; but now, the pendulum may have swung too far in the positive direction, appearing to show little concern about weak global growth, a still-sluggish U.S. economy, ongoing trade uncertainty, and weak earnings. Paramount among concerns is investor sentiment. Ned Davis Research aggregates a number of well-watched sentiment indicators into its Crowd Sentiment Poll, covering both attitudinal and behavioral measures of sentiment. It has recently moved from the extreme pessimism zone to the extreme optimism zone in a very rapid fashion—barely pausing in the neutral zone. A pullback, and the pendulum moving more toward a center point, would likely be viewed as healthy. We continue to reinforce our view that investors should not get over their skis and allow equity exposure to increase so much that it changes portfolios’ risk profiles; but instead to consider periodic rebalancing. Within U.S. equities, we continue to be biased toward large-cap stocks over small-caps due to the higher debt profile among small caps, as well as the record-large percentage of profitless small cap companies.

Economy perking up

As the temporary factors moved further into the rearview mirror, first quarter gross domestic product estimates were generally been rising. Estimates for first quarter real gross domestic product (GDP) began moving up last month as well. However, the business side of the economy tells a little less rosy story. According to the Federal Reserve, industrial production fell 0.1%, confirming continued corporate caution as seen in the rolling over of corporate confidence among both small and large businesses.

Continued trade uncertainty is likely one of the culprits of deflated “animal spirits.” We’ve been hearing about a potential imminent China/U.S. trade deal for a couple of months now, but nothing has come to fruition yet. The waiting game can create some paralysis among corporate decision makers. Our view is that the market has priced in some semblance of a deal; and that there is upside “risk” if it’s a stronger-than-expected deal, but downside risk in a no deal scenario. We don’t believe investors are factoring those possibilities into their investing theses; and the potential for a trade surprise or two could result in added volatility.

Fed change

Also interesting lately has been the apparent softening of the Fed regarding their implied 2% target level of inflation. While that may sound appealing in this low inflation environment, we remain a bit concerned that the tight labor market—especially if the economy accelerates out of its soft patch—could lead to an uptick in inflation. If the Fed were to move toward this more flexible view of inflation, it would increase the chances the Fed might get behind the curve. This is not an imminent problem, but not something to keep on the radar screen.

An additional factor in the recent rally in U.S. equities has likely been the perceived rebound in Chinese economic activity. The stock market isn’t the only thing that is up; with China’s industrial production surprisingly strong in March. A trade deal with the United States is unlikely to turn around China’s economy. A trade deal which removes some higher U.S tariffs on Chinese goods could have a positive impact on Chinese exports. However, China’s exports to the United States have continued to grow despite the tariffs, so any rebound in exports upon reaching a trade agreement may be modest. We will be watching to see whether the current stimulus-driven economic stabilization transitions into a self-sustaining recovery in the absence of new stimulus.

So what?

U.S. equity market gains since the Christmas Eve 2018 low have been impressive, and we don’t think a recession is in the near-term future—but sentiment is extended and investors should be cautious about chasing gains at this point; either in the United States or emerging markets. A near-term pullback would likely be healthy and could afford a better opportunity for investors who are looking to add equity exposure. On the other hand, those investors whose portfolios are now holding an outsized equity allocation could use the latest strength to rebalance back toward targets.

 

Important Disclosures

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

Ned Davis Research (NDR) Crowd Sentiment Poll ® shows perspective designed to highlight short- to intermediate-term swings in investor psychology.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

 

Content provided by Charles Schwab, Hong Kong
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