Every Christmas Eve, I read "A Christmas Carol" to the kids in our family. I'm always moved by Charles Dickens' classic about human redemption. Which brings me to the Ghost of Christmas Past.
Last year around this time, as Thanksgiving and Christmas beckoned, stocks were on the cusp of a correction. The Dow Jones Industrial Average and the S&P 500 recorded their worst December performance since 1931. For the fourth quarter, the S&P 500 and Dow plunged 13.9% and 11.8%, respectively. The tech-heavy NASDAQ plunged 17.5%.
The three major U.S. stock indices concluded a volatile 2018 with their worst yearly performances since the great financial crisis of 2008. The S&P 500, the Dow, and the NASDAQ finished the year with losses of 6.2%, 5.6%, and 3.9%, respectively.
Major indices outside the U.S. got clobbered even worse in 2018. China's Shanghai Composite fell 24.6%, Japan's Nikkei 225 Index fell 12.1%, and Europe's Stoxx 600 fell 13.2%, the worst declines for all three indices since the 2008 crisis.
Maybe you've forgotten last year's correction, which was in large part triggered by recession fears. Like the ghost in Dickens' tale, I'm here to remind you of the past and how it could be a harbinger of the future.
Will we see a repeat this year? The threat of recession still looms. What's more, the divergence between corporate profits and high stock prices doesn't bode well. After all, the foremost driver of stock market gains is corporate earnings growth.
When the books close on third-quarter earnings season, profit growth for the S&P 500 is expected to come in at -1%, marking the third straight quarter of earnings declines. We're officially in what's called an "earnings recession," which is defined as two consecutive quarters of earnings declines.
And yet, stocks trade at record highs. That's because there's still plenty of positive news to go around. In the U.S., unemployment is at a 50-year low, inflation is tame, interest rates are low, businesses are reaping the benefits of de-regulation, and companies (especially in the technology sector) are flush with cash.
The U.S. economic expansion is frayed but intact (for now). However, factory activity is sputtering, business investment is contracting, and CEO confidence is imploding.
The threats abroad…
The greatest risks to stocks come from overseas. Britain is scheduled to conduct a national election on December 12 that's shaping up to be particularly nasty, with the fate of Brexit hanging in the balance. Whether Brexit turns out to be "soft" (with an exit plan in place) or "hard" (the UK crashes out of the European Union without a plan), the UK and by extension the EU will take big economic hits.
Read This Story: Rue Britannia: What Brexit Means for Investors
At the same time, manufacturing activity is slowing in major overseas growth drivers, such as China and Germany, and unrest is worsening in hot spots such as the Middle East and Hong Kong. An external foreign shock could trigger a correction in U.S. and foreign stock markets.
Stocks are frothy and ripe for a fall. My preferred valuation yardstick is the cyclically adjusted price-to-earnings ratio (CAPE), and it shows that stock values are off the charts.
The influential Professor Robert Shiller of Yale University invented the CAPE ratio (also known as the Shiller P/E) to provide a deeper context for market valuation.
The CAPE ratio is defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation. The ratio now stands at 30.6, which is 84.3% higher than the historical mean of 16.6.
We've been witnessing a wide gap between the S&P 500 index and corporate profits, similar to the divergence that emerged around the past two recessions (see chart).
The wild card in this equation is the Federal Reserve. If economic conditions deteriorate further, the Fed will have a strong case to cut interest rates again when it meets in December. However, Fed Chief Jerome Powell yesterday indicated that the Fed probably wouldn't cut rates anytime soon.
Where to invest now…
With interest rates still at low levels and growth stocks overvalued, high-dividend utilities are an especially attractive hedge now. Utilities stocks have enjoyed a good run this year but there's still upside left. Click here for the best utility stocks.
Bonds have enjoyed a nice run this year, too. During bouts of uncertainty, investors flee to safety. They typically have used bonds as a safe haven until the financial turbulence has passed. This demand causes bond prices to climb and their yields to drop. Accordingly, U.S. Treasury yields fell Wednesday as optimism waned that the U.S. and China would reach a deal to remove tariffs.
Amid these conditions, how should you allocate your portfolio? Generally speaking, it makes sense to divvy up your portfolio with 50% stocks, 25% hedges, 15% cash, and 10% bonds.
One way to mitigate risk and still garner growth is to pinpoint "mega-trends" that will unfold regardless of terrorist attacks, oil supply disruptions, or interest rate policy. One such trend is the roll-out of 5G, the next generation of wireless technology. Click here for the best 5G plays.
Stocks could have further to run, but you should take protective measures. Let's say you're nearing or in retirement and you need to tap your retirement nest egg within the next 10 years. Sure, stocks tend to rise over the long haul, but there's no guarantee that they'll always post a gain during any given 10-year period.
Sometimes, during a decade's time frame (for example, from 2000-2010), stocks have posted a negative return. Stay cautious. Investment mistakes come back to haunt you later.
Questions or comments? I welcome reader emails: mailbag@investingdaily.com
John Persinos is the managing editor of Investing Daily.
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