The global economic expansion and equity bull market that followed the Global Financial Crisis (“GFC”) is well past the nine-year mark, making it the longest bull-run in US history.
While economic fundamentals are still sound in the US, and bull markets rarely die of old age, there are important indicators of the frail nature of the current environment. Market volatility in October and November 2018 was a stark reminder of the risks involved in equity investing, a feature that had been all-but-obscured by the long bull-run.
We expect that the future will look quite different from the past nine-plus years of rising equity and bond markets amid low volatility. At this juncture, several key market indicators are currently at historically high or low levels, suggesting ample potential for mean reversion.
Despite the more recent correction, valuations in US equity markets continue to appear stretched and suggest low potential returns going forward, volatility in equity markets remains at historical lows and there is a wide dispersion between the narrow segments of the market that have led the rally (US, China, technology and growth/momentum stocks) and the rest of the market (international, defensive sectors and value stocks), which exhibit more attractive valuations.
Since March 2009, the US market generated over 400% cumulative returns, outpacing international equities by over 200%; growth has outperformed value in the US by over 100%; and five US stocks have contributed over 50% to S&P 500 Index returns, year-to-date.
In addition, market volatility is expected to increase as the Federal Reserve and central banks across the globe exit accommodative monetary policies, global growth continues to soften, and markets process idiosyncratic events such as Brexit, China-US trade tariffs and other.
All of these features will likely make for choppier markets ahead and a long overdue potential repricing of risk and return.
Repositioning for the Markets Ahead
While financial markets rarely adhere to the Gregorian calendar, the start of the New Year usually offers investors an opportunity to revise their views, rebalance and reposition their portfolios.
Market corrections (declines of 10% or more) typically occur once a year. Over the last 80 years we’ve had 12 recessions but over 43 greater-than-10% market corrections. While obscured during the most recent narrowly driven bull market, such sell-offs are a reminder of the value of diversification. How much more room for growth in equity markets is there really given current levels?
The secular shift in the relationship between stocks and bonds, coupled with a potential increase in volatility in equity markets, implies that investors may have to look beyond traditional portfolio construction approaches and traditional equity exposure. Many investors have begun looking beyond the traditional 60% stocks/40% bond portfolio -- both at the asset allocation level, via exposure to truly uncorrelated return sources within alternatives; and within the equity sleeve, making adjustments to address the increased beta and volatility associated with certain factor and sector exposures.
Diversification Beyond Stocks and Bonds
Stocks and bonds have historically realized a negative correlation. However, since the global financial crisis, correlations have gradually climbed, with both asset classes largely rising in tandem.
As volatility has started to ripple through markets, stocks and bonds have accrued losses simultaneously — diluting potential diversification benefits. This leaves investors to consider the portfolio implications as the long-term complementarity between these asset classes begins to fray.
Rising Equity-Bond Correlations
Source: Standard & Poor’s, Barclays Indices, eVestment.through [date]. 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.
Market environments in which stocks and bonds are positively correlated, such as the 1970-1990 period, require investors to resort to alternative sources of portfolio diversification. Equity market neutral strategies offer this diversification benefit and the opportunity for gains regardless of market direction, making them a compelling option for investors seeking to capitalize on diversification.
Defensive Equity: Equity Exposure with a More Attractive Risk Profile
Amid a trending and narrowly driven market, such as the one experienced post-global financial crisis, many investors may find their portfolios have increased exposure to Growth/Momentum factors and underlying consumer-facing technology companies (housed within Consumer Discretionary, Telecommunication Services and Information Technology sectors).
Taking on unintended risks increase a portfolio’s vulnerability to pronounced drawdowns as trends reverse. Factors such as High Dividend and Minimum Volatility and sectors such as Utilities and Consumer Staples, which have lagged since the global financial crisis, have exhibited a significantly lower beta to the market and realized a lower standard deviation versus their cyclical counterparts.
Factors and Sector Risks, 2018 Year to Date
Source: Standard & Poor’s, eVestment and Bloomberg. Factors represented by equivalent MSCI factor Indices and Sectors represented by S&P 500 Index GICs, Level 1 Classification. 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. Figures reflect period of Oct. 1 through October 31. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
An allocation to defensive equity strategies, providing exposure to stocks with lower price volatility, higher dividends and strong earnings/profitability, adds a differentiated return stream with potentially more attractive risk-adjusted returns than the broad equity market.
2019 Investment Outlooks
The Limits of U.S. Growth
An Extended Business Cycle
Liquidity is the Question
A Plethora of Risks
Current Volatility, Long-Term Opportunity
Choppy Markets Ahead
Time to Get Defensive?
Royce & Associates
A Shift Toward Cyclicals
Focus on Growth
Download The Full Report
Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.
The Bloomberg Barclays U.S. Aggregate Bond Index is an unmanaged index that measures the performance of the investment grade universe of bonds issued in the United States. The index includes institutionally traded U.S. Treasury, government sponsored, mortgage and corporate securities.
"Brexit" is a shorthand term referring to the UK vote to exit the European Union.
Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
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.
Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses and have a potentially large impact on Fund performance.
Diversification and asset allocation strategies do not assure a profit or protect against market loss.
Dividends represent past performance and there is no guarantee they will continue to be paid.
Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.
This material is only for distribution in those countries and to those recipients listed.
All investors and eligible counterparties in EU and EEA countries:
In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.
In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.
Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.
All Investors in Hong Kong and Singapore:
This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.
This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.
All Investors in the People’s Republic of China (“PRC”):
This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.
This material has not been reviewed by any regulatory authority in the PRC.
Distributors and existing investors in Korea and Distributors in Taiwan:
This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.
This material has not been reviewed by any regulatory authority in Korea or Taiwan.
All Investors in the Americas:
This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
All Investors in Australia:
This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.