U.S. stock market investors are worried. That’s the bad news—and the good news.
There is no shortage of risk on Wall Street, and cautious investors can point to any number of factors—including high valuations, geopolitical tensions, and policy uncertainty surrounding both the Federal Reserve and the U.S. government—as a reason why the market’s seemingly unending bull market could come to a screeching halt.
Such headwinds could limit the market’s upside potential. At the same time, however, the mere acknowledgment of such concerns could diminish how risky they actually are, as the more investors fret about them, the more they’re priced into shares.
“We do not expect an imminent drawdown, but the risks identified most frequently by clients may limit medium-term SP 500
upside,” Goldman Sachs analysts wrote in a research report. However, the investment bank added: “Persistently cautious investor sentiment is one reason we expect limited downside from any economic or policy-related disappointment.”
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Goldman has previously stated that because investor euphoria is “nonexistent, an imminent start of a long decline seems unlikely.” However, the analysts did see reasons why the market could struggle going forward, noting that the Institute for Supply Management manufacturing index was above 60, a strong reading that nevertheless “typically marks the peak of growth and presages economic and equity deceleration.”
“Investors buying the SP 500 at ISM readings of 60 or higher have gone on to suffer negative three- and six-month returns on average as economic activity slowed,” wrote David Kostin, the firm’s chief U.S. equity strategist. “In other words, an environment of synchronized global growth acceleration today raises the risk of coordinated global slowdown tomorrow.”
Despite that, it speculated that near-term market direction would be dependent on whether tax reform passes in Washington, saying the issue was “the key potential upside and downside risk to equity markets.”
“We estimate tax cuts could lift 2018 earnings per share by 7%…, suggesting that tax reform optimism has contributed to the 5% SP 500 rally since late August,” Goldman wrote. “If developments in Washington lift the odds of tax reform closer to 100%, or hint at larger cuts than we currently expect, SP 500 could continue to rise toward 2,650. On the other hand, a collapse in expectations would likely mean the reversal of the market’s recent 5% rally.”
Other institutions joined Goldman in seeing near-term risks.
The Wells Fargo Investment Institute wrote that “this is a good time to take profits from U.S. equities and reallocate to areas of the markets where allocations are below target weightings.” It added that valuations “appear more reasonable” for overseas markets.
Morgan Stanley noted that the 14-day relative strength index for the SP 500 has been above 70 for 15 straight days, a level it said was considered “overbought territory from a momentum perspective.” In the past, such rallies have been followed by pullbacks in the subsequent 30 days, with a median decline of 4.5%.
“We now believe the market may take a pause here before ultimately ascending to 2,700 early next year,” the investment bank wrote.
A pause is long overdue, historically speaking. It has been 20 months since the most recent SP 500 correction, defined as a 10% drop from a peak, and 332 trading days (16 months) since the latest drop of 5%, the fourth-longest such streak in history. Historically, there is a 5% drop every 92 days, on average.
Even smaller dips have been nonexistent. The SP 500 hasn’t had a 3% decline in more than 11 months, the longest such streak ever, and it has gone 33 straight days without a 0.5% decline, “the longest streak since 1995,” according to LPL Financial.
Beyond the bull market, the U.S. economy overall has been enjoying an atypically long period of growth. Bespoke Investment Group noted that the current economic expansion “has now joined the 100-month club,” a rare occurrence, and more than twice the average length of expansions, which is 46 months. Going back to 1900, there have only been two expansions that lasted for longer, with the lengthiest, at 120 months, starting in March 1991. While the bull market started in March 2009, when the stock market bottomed after the financial crisis, the economy resumed expanding in June 2009.