Is the Market Bracing for a Pullback?

July 2017
  

After celebrating an eight-year milestone in March with a cumulative return of 314%,1 could the second-longest bull market be ready for a pullback?

  

The new administration’s ability to deliver on pro-growth policy, the current bull market’s rapid growth trajectory, and stretched stock valuations have raised concerns about a looming pullback.

Stock Valuations Appear Stretched

While measures such as below-average market volatility and high investor optimism might support a continued market rally, it’s hard to ignore that stocks have become increasingly expensive. The Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE), a market indicator and common measure of stock market valuations, is hovering at levels seen just ahead of the financial crisis and other periods followed by notable market declines. CAPE stands well above its long-term average, indicating that stocks are overvalued and lower equity returns may lie ahead.

Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE)

Source: Bloomberg as of 6/30/2017. Past performance does not guarantee future results.

Market Downturns are Normal

The longer-term sustainability of the current bull market may be uncertain, but we do know that market downturns are a normal part of the business cycle. Pullbacks and corrections occur periodically as markets recalibrate after getting overextended from time to time. A look back shows there were pullbacks every year over the last 35 years.2 Market downturns can present opportunities for investors. However, investors tend to sell during market downturns and buy during upswings. Poorly timed investment decisions can negatively impact long-term portfolio results.

Consider Long-short Investing as a Hedge

Today’s investors are faced with a very important challenge—finding returns in market upswings and protecting their portfolio during market declines. Long-short strategies are designed to offer investors something most long-only strategies cannot: potential downside protection. In fact, long-short strategies have effectively provided downside protection during the two largest equity market downturns in the last 15 years. During the tech bubble, when the S&P 500 declined 23%, long-short strategies lost only 1%.3 Similarly, when the S&P 500 declined 51% during the financial crisis, long-short strategies were down 28%.3

Dealing with market volatility requires a long-term perspective and a good portfolio strategy. Directing a portion of a portfolio’s equity allocation to a long-short strategy may help to provide the downside protection investors need to weather the periodic ups and downs of the market.

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1Source: Morningstar as of 3/9/2017. Calculated by PGIM Investments using data from Morningstar. All rights reserved. Stocks are represented by S&P 500 Index.
2Source: Morningstar as of 12/31/16. Calculated by PGIM Investments using data from Morningstar. All rights reserved. Used with permission. Stocks are represented by Ibbotson US Large Stock Index.
3Source: Morningstar, Lipper as of 12/31/16. Calculated by PGIM Investments using data from Morningstar. All rights reserved. Used with permission. Indexes are unmanaged and do not include fees and expenses. Long-short is represented by Lipper’s Alternative Long-Short Equity category. Past performance does not guarantee future results.

Definitions—S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. It gives a broad look at how U.S. stock prices have performed. Pullback is a price decline of at least 5% and less than 10% in stocks, bonds, commodities, or indexes from a recent high. Corrections is a price decline of at least 10% in stocks, bonds, commodities, or indexes from a recent high. Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE) is a valuation measure usually applied to the U.S. S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. Ibbotson US Large Stock Index is an unweighted index which measures the performance of large-cap stocks. Black Tuesday happened on October 29, 1929, and marked one of the largest one-day drops in stock market history. It effectively ended the Roaring ’20s and led the global economy into the Great Depression. Dot-com refers to a bubble that occurred in the late 1990s and was characterized by a rapid rise in equity markets fueled by investments in Internet-based companies. Investors cannot invest directly in an index or average.

 

0307229-00001-00 Ed. 07/2017