Reasons to Expect a Market Pullback and What to Do About It

The essence of Buddhist philosophy as I understand it is that everything is temporary. Night follows day. Good times follow bad times. And the cycle continues. We see that when it comes to the economy and economic data. A recent Bureau of Economic Analysis report (June 11, 2021) noted first-quarter Growth Domestic Product (GDP) up at an annual rate of +6.4%. This was on top of strongest readings in forty years for manufacturing and service sector indices. And corporate earnings continue to show positive surprises. Coronavirus cases continue to drop in the US and state and federal government restrictions continue to ease leading to the Great Reopening.

On the other hand, it was just about a little over a year ago (March 2020 to May 2020) that we saw pandemic-induced lows. Are we out of the woods? Is it really business as usual? As much as I want to be back to “normal” there are still many reasons to expect a market pullback and here’s what to do about it. Should you worry? That depends. If you have a plan and remember that everything is temporary, you should be alright.

#1. Stock Valuations Are Lofty

The total return adjusted stock Price/Earnings ratio for the S&P 500 is now above 38 on the global economic re-opening. Although not quite at pre-tech 2000 bubble levels, this leaves valuations in their 98th historical percentile, placing continued growth and contained inflation under the microscope each quarter ahead. Other metrics, like the Price-to-Sales ratio and the 200-day moving average suggest that valuations are at the extreme high end of the scale. According to the Buffett Indicator, the ratio of US stock valuation to US GDP, we are in “strongly over-valued” territory.

#2. Frenzied Nature of the Market

Just check your local real estate listings. Residential real estate is soaring in value over the past year. Offers significantly higher than list price are now the norm. Commodities are also very expensive.  (Have you tried pricing new wood floors or a home improvement?) There are also these financial entities called Special Purpose Acquisition Companies (SPACs) designed to be a way to finance or acquire start-ups. While around for decades, more than 311 of these SPACs were launched in 2021 alone. In addition to this there are high valuations and a lot of IPOs over the past year. Add to this the trillions in various federal government stimulus packages putting cash in the hands of individuals, companies, and even local and state governments. All of this is leading to concerns about inflation.

#3. Earnings Comparable Will Get Tougher

Year-over-year comparisons of stock metrics look great now. Coming off the lows brought on by the pandemic, things like sales, inventories, and earnings have shown huge bounces. But as time goes on, this effect is going to wane. Stock prices are designed to factor in things like earnings and expectations of revenues and profits. A stock price reflects the net present value of future cash flows. Right now, it seems that prices reflect “perfection” so any disappointment will likely be met by a swift reaction by investors.

#4. VIX Levels Suggest an Unprepared Market

The CBOE Volatility Index (VIX) measures volatility and is known as the “fear index” because it is a gauge of implied volatility of S&P 500 index options. So, it is used by traders to trade on the current and expected volatility in S&P 500 stocks.  Right now, the VIX is well below twenty indicating expectations of low volatility. At these levels it signals that investors are comfortable with where the market is which may be giving false hope to many. Investors may not be prepared for unexpected bad news. And market corrections can happen with or without a “trigger.”

While we’ve had our share of “black swan” events which can happen without warning, there is also the still real possibility that COVID infection rates here or abroad could spike or even a separate spike in interest rates could raise the VIX and lead to sharply lowered expectations of the prospects for stocks.

Given the recovery from pandemic lows and the good economic news, the VIX seems to indicate that investors are ignoring the potential for risk and are being lulled into a sense of complacency.

#5. The Market Has Had at Least One 6.5% Pullback Each Year Since 2000

One of the longest bull markets was born on March 9, 2009. It was born in the midst of a deep and seemingly existential crisis. While that bull market lasted for about eleven years, it wasn’t a constant straight line up. And history has shown that a 5% to 10% pullback in the S&P 500 index at least once each year is very normal. And we’ve seen at least such a pullback each year for the past twenty. In fact, the average pullback is about 6.5%. While history rarely repeats, it does rhyme. So, it would be a surprise if the bears didn’t come out at some point during 2021.

#6. Seasonal Tailwinds May Become Headwinds

There is an old saying when it comes to investing: Sell in May and go away. Historically, this pattern does exist. May 1st through October 31st represents the weaker half of the year for stock market performance. And 2021 is the first year of a presidential cycle which is often negative. And as infrastructure and tax policies wend their way through Congress, we may see adverse market reactions to such policies. Analysis provided by Ned Davis Research Group shows the historical patterns of one-year, 4-year Presidential, and Decennial cycles. Their projections call for a continued run-up with a summer rally through mid-August 2021 in line with the “sell in May” phenomenon followed by a short, sharp drop before another significant drop near Labor Day lasting through early October.

#7. Everyone Is on the Same Side of the Trade

The largest concern has to do with investor sentiment. Everyone from Main Street to Wall Street is optimistic about the outlook for US stocks. Individual investors are pretty bullish with a one-year bullish high of about 57% according to the AAII Investment Sentiment Survey ending April 7, 2021. Professional investor surveys show a similarly bullish sentiment. A net 78% of professional investors expect global profits to be up over the next twelve months. Nearly 70% of the same group of professional investors expect above-trend growth, the highest reading ever. When every market participant has the same sentiment, it can often end with disappointing results. See #4 above.

#8. Inflation May Not Be Transitory

As noted in #2 above, lots of “things” are moving up in price. Lumber prices are higher than at the end of last year. Gasoline is over $3/gallon as demand has increased coupled with supply issues. Copper hit its highest level in 10 years. Home prices are gaining at the fastest rate in 15 years. The Fed’s preferred measure of inflation (Personal Consumption Expenditures – PCE) saw the biggest monthly move since 2009. And Employment Cost reports showed the best quarterly wage growth since 2021. Good news for workers but a potential impact on consumers.

The Fed has announced that they see these moves as transitory and temporary as pent-up demand is met after a pandemic. But some economists disagree.

#9. All Good Things Come to an End, Eventually

Just as the Buddha has said, everything is temporary. Despite strong economic data which has been helped by various federal stimulus programs, this can’t last forever. Current growth rates are not sustainable just on stimulus alone and pent-up demand. Eventually, stimulus checks end and pent-up demand is satisfied. At some point, the forward-looking stock market will have to adjust its view as everything reverts to the mean and slows down. Eventually, the Fed will begin a concerted effort at raising interest rates. The view now is for that to be around November 2022. When that tapering begins, it’s likely that the prospects for stock prices will change as well.

What to Do About a Market Pullback

So, there are plenty of reasons to expect a market pullback. And now what to do about it.

Generally, the second year of a bear market recovery is still positive even if muted. And we are in that second year. And as has happened before, the market can continue to go up – for up to two years – even with warnings of “irrational exuberance” as happened after then-Fed Chairman Greenspan made that famous comment.

Risk Management Makes Sense

Reading tea leaves and crystal balls is not my specialty. Since I cannot predict when a market pullback, correction, or worse may hit, I will stick to commonsense risk management principles.

First, investors need a plan that includes an estimate of how much they are willing to put at risk and potentially “lose” in the short term. While you only really lose if you sell, the mere fact that an investment statement shows a lower value in subsequent months is unsettling. To avoid making emotionally-charged decisions (like “sell everything, raise cash”), you need to know what is the optimal allocation to risky (i.e. stock) assets that aligns with your risk tolerance, capacity, and timeline. This allocation will be coupled with an allocation of cash to cover fixed overhead for a chosen time period (ranging from six months for the more risk tolerant or younger client to three years for the more risk averse or older client). To further mitigate the impact of a correction, we will continue to use a select number of quality dividend-paying stocks from the list of Dividend Aristocrats because these provide income and tend to do better when there is a correction. Another risk control device is to include an allocation to alternatives like gold, natural resources and real estate. Finally, we believe that being agile helps. For us, that means being willing to shift allocations among sectors using specific sector ETFs as market conditions may dictate.

By having a core allocation supported by allocations to overweight specific sectors and buffered by allocations to cash and alternatives, our MarketFlex Portfolios are designed to adapt to ever-changing market conditions.

While there are many reasons to expect a market pullback, you now know what to do about it. Employing a risk-managed approach to your portfolio can provide an investor with good reason to not panic about inevitable corrections in the stock market.

NOTE: Originally posted 6/14/2021 by Steve Stanganelli, CFP®