Getting the Most out of the Late Cycle Equity Market

Getting the Most out of the Late Cycle Equity Market

Lower volatility stocks with sustainable dividends and attractive valuations may provide a defensive tilt to portfolios in a late cycle environment.


The S&P 500 managed to squeak out a modest gain in the third quarter of 2019, allowing U.S. stocks to hold onto their biggest year-to-date gains in more than two decades, and prolonging one of the longest bull markets on record. The S&P 500 enters into the fourth quarter with 19% returns for the year, marking its best performance since 1997.

However, uncertainty simmers underneath. Safe-haven assets, such as U.S. Treasuries and gold, have risen alongside U.S. stocks and low volatility and high-income equity funds have continued to see an increasing amount of market flow over the period. The top performing sectors over the third quarter were Utilities, Real Estate and Consumer Staples, and Utilities and Real Estate are two of the top three performing S&P sectors year to date.

Q3 2019 S&P 500 Sector Return

Source: Bloomberg, S&P 500 Index. Based on GICS sector return from June 30, 2019 through September 30, 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Despite the S&P 500 sitting just 1.6% below July’s all-time high, warning signals have begun to flare, including the inversion of the 2- and 10-year segment of the U.S. yield curve in August; extreme swings in performance of value and momentum stocks in September, with value experiencing its best day since December 2001 and momentum experiencing its worst two trading days in the past ten years; world trade flows set to increase to their weakest pace since the global financial crisis;1 and the Institute for Supply Management Index (ISM) falling to a ten-year low.

However, the U.S. economy still broadly remains supportive driven by strong employment and consumer spending numbers, and domestic equities continue to look attractive from an income perspective, as negative yields around the world continue to leave investors starved for yield.

Historically, an inversion in the U.S. yield curve has preceded a recession by an average of 14 months, and in multiple cases the period between one and the other has been closer to 2 years.

Time From 2s-10s Yield Curve Inversion Until Recession Starts

Source: Bloomberg. Short-term dated bond yield represented by the 2-year yield index and long-term yield represented by the 10-year bond yield. Time to recession is calculated as the time between the final sustained inversion of the yield curve prior to the recession, and the onset of recession. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Additionally, as shown in the exhibit below, U.S. equity market returns have been exceptionally robust prior to a peak in equity markets.

Historically Robust Equity Returns Pre-Peak Average Total Equity Return 1945-2018

Source: FactSet, Robert Shiller, S&P 500 Index, JP Morgan Asset Management. Chart is based on return data from 11 bear markets since 1945. A bear market is defined as a decline of 20% or more in the S&P 500 Index. Monthly total return data from 1945-1970 is from the S&P Shiller Composite Index. From 1970 to present, return data is from Standard & Poor’s. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Facing continued market uncertainty and the growing likelihood for increased volatility shocks, it is important for investors to identify lower volatility, sustainable dividend paying stocks that are also attractive from a valuation perspective. Investors should be cautious buying purely low volatility stocks at any valuation as low volatility investing without consideration of fundamentals, may be prone to sharp reversals.

Dividend paying companies which offer a lower volatility profile and continue to trade at a discount to the broader market, and provide exposure to the value trade in addition to offering a defensive tilt. As such, they allow for equity market participation with less vulnerability to a late cycle correction or negative market shock.


Footnotes:

1 Based on data from the World Trade Organization. The organization now expects flows of goods across borders to grow by just 1.2% this year, down from 3% in 2018.

Definitions:

The Global Industry Classification Standard (GICS) is a standardized classification system for equities, developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poors.

The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.

Momentum refers to an investment approach that aims to capitalize on the continuance of existing trends in the market.

The S&P Shiller Composite Index is a measure of U.S. stock prices comprised of a data set that consists of monthly stock price, dividends, and earnings data and the consumer price index (to allow conversion to real values), all starting January 1871.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

Value refers to an investment approach that aims to select stocks that trade for less than their intrinsic values.

The World Trade Organization (WTO) is an intergovernmental organization which regulates international trade.

The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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