Investors remain skeptical about embracing stocks given the recent rally. Volatility in 2016 has been sharp and dramatic to the upside and downside. Following the devaluation of the Chinese currency in January, the S&P 500 experienced its worst start to a calendar year ever! Worse than 1929, 1930, 1979, 1987, 2000, 2001, 2008, and 2009. However, from February 11 until June 23, the S&P 500 rallied 14%. Then Brexit happened. Over the next two trading days, stocks fell on average more than 5%. After taking a deep breath, from June 28 through the month of August, stocks rallied 9%. This volatility has programmed investors to expect the next shoe to drop, but will it happen?

This is a very difficult question to answer. Stocks will most definitely sell off, the question is when? For the past 36 years, the average drop in the S&P 500 during the course of a year from peak to trough was 14% (this includes the 34% intra year sell off in 1987, 49% in 2008, and 28% in 2009). Yet the S&P 500 finished positive 27 of those 36 years!* Given all of the turmoil over the past several years in the stock market, investors should understand that a market downturn doesn’t signal the end of the world, but rather a long term buying opportunity. Without a crystal ball, timing a sell-off is impossible. Yet there is a sense among the investment community to brace for a big storm.

Typically, if stocks rise, bonds fall, and vice versa. However, 2016 has seen bonds rally along with stocks. Ironically, for as much distrust as there is of stocks, investors are very skeptical of bonds. Rates can’t stay low forever, can they? Long dated bonds are not attractive at the present moment. Although Fed language has been an enigma, the case to raise rates is building again. Historically, US Treasuries have offered risk-free-returns, yet with yields as low as they are, investors could be buying return-free-risk. At current prices, US Treasuries are expensive protection for a stock market sell off.  

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Stock valuations are not table pounding cheap, yet far from bubble territory. However, the environment remains supportive for stocks: inflation is low, global central banks are accommodative, corporate balance sheets are flush with cash, and nearly 65% of the stocks in the S&P 500 have a higher dividend yield than the US 10 year Treasury. Finally, and most importantly, last quarter, nearly 70% of the companies in the S&P 500 have once again outpaced Wall Street analyst expectations, signaling that the estimated “E” in the P/E (price-to-earnings multiple) may be understated.

Now is a good time to add to sectors that are underweight in the portfolio. Financial stocks look compelling. The market is convinced interest rates will be lower for longer. Bank stocks have suffered. Also, look at cyclically sensitive stocks for compelling long term investment ideas.

On the other hand, the utility sector looks expensive. Global investors have piled into bond like proxies. Utilities fit that bill. After posting a negative 5% total return in 2015, Utilities are up nearly 15% in 2016, and in some cases trading at premium to the S&P 500 on a price-to-earnings basis.

What to do? Remain disciplined to rebalancing your portfolio. Review your allocations among stocks, bonds and cash. Dive deeper into each asset class and make sure one sector, or credit quality, is not dominating the portfolio. Continue to allocate equities in your taxable accounts and fixed income in your tax sheltered accounts. 

Your asset allocation strategy should be consistent with your risk tolerance and investment objectives. Short term volatility in the stock market should not alter your long term financial goals. Finally, diversification remains key. Make sure your combined portfolio allocation does not fully lean to one side of the boat. Investors that remain disciplined to spreading out risk and rebalancing to an equity target regularly will build solid investment returns for the long term.

* JP Morgan Guide to the Markets, 6/30/16, pg 12

Note: John J. Petrides, MBA, is a Managing Director and Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit. 

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