Maintain Perspective When Near-Term Volatility Surfaces

Maintain Perspective When Near-Term Volatility Surfaces
new sense photo brian selzer

OCEAN CITY — U.S. stocks have been resilient this year but the summer months may prove noisy. We remain constructive on them in the medium term, but believe the risks of a pullback in the near term have grown. As such, investors, especially those with overweight positions relative to their strategic allocations, should be prepared to navigate near-term volatility.

The context is important here. Stocks in the U.S. have had a great run, rising over 200% from the depths of the financial crisis. Growing corporate profits, central bank liquidity and improving economic activity have anchored equities and propelled them to new highs. Any pullbacks, especially in the last three years, have been swiftly bought up, leading to even greater highs. However, some of the factors that have aided equities have become near-term headwinds.

As we enter the summer months, seasonal factors suggest a greater risk of a pullback In particular, there are three areas of concern for stocks. First, recent economic data in the U.S has been disappointing. In the first quarter, the economy grew only 0.2%, well below expectations. A plunge in oil prices and rapid appreciation of the dollar since last year finally showed up as drags on growth. The data also shows that the expected strength in consumer spending has yet to materialize. Real consumer spending was only up 1.9% in the first quarter after rising at an average annualized pace of 2.9% in 2014, according to the BofAML Global Research economics team. Consumers may have become more conservative in the wake of the financial crisis with anemic wage growth and more volatile incomes. All in all, the team has reduced its forecast for growth this year to 2.4%, projecting a pickup through the rest of the year.

Second, the Federal Reserve (Fed) is en route to raising interest rates in the latter half of the year.

Finally, prospects for growth in corporate profits have diminished recently. Stocks tend to be forgiving if companies are growing earnings. However, a decline in profits in the energy sector and a drag on multinationals due to a stronger dollar have brought down earnings per share forecasts for the S&P 500. The BofAML Global Research equity strategy team sees them declining by 1% this year.

To be sure, we remain constructive on U.S. equities in the medium term. We think the recent weakness in economic activity will reverse, although with less vigor than we saw in the second quarter of last year. We also think corporate profits will recover in the second half of the year and rise by roughly 7% in 2016. This means stocks may behave in one of two ways: They remain resilient, looking past the potential softness in economic activity and earnings, or they pull back as nervous investors take profits and wait for better opportunities.

Our recommendation for most investors is to stick with their goals-based portfolios. However, it is always prudent to have an understanding of the macro factors shaping future returns and manage around developing risks at the margin. We think investors should not rush into raising the risk levels of their portfolios based on the news flow or sentiment, especially those with bullish positions already in place. It may be prudent to consider strategies and investments that can withstand or even benefit from higher volatility.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)