Equities: Time for selected profit taking and/or switches to lower beta

Roger Keller

A maturing bull market

July marks the 121th month of the current period of economic expansion, based on US data. It becomes the longest. The equity bull market also has a respectable age, as it started in March 2009. It is still running but earnings growth is decelerating and valuations have become less attractive, going from cheap to fair (The Price-to-Earnings went from 9 to 15, the Price-to-Book from 1.2 to 2.1).

Bad news is good news

Deteriorating economic fundamentals have logically led bond yields to new lows and gold to a new high. Equity investors preferred to look elsewhere. Instead of focusing on the deteriorating economic and earnings trends they took rising alarm at central banks positively, considering that rate cuts will in the end reflate the economy and revive earnings growth, or at least keep them growing for longer.

Earnings are vulnerable

While recent data put question marks on the likelihood of an economic reacceleration in the second half of the year, 10 out of 24 strategists have recently downgraded their S&P500 EPS forecasts for 2019, according to Bloomberg. The key issue is not really sales growth, which are decelerating but risks to margins, coming from rising wages and lack of pricing power.

An unattractive risk-reward relationship

Marginal earings-per-share growth, fair valuations and high levels of uncertainty limit the upside. Downside risk is limited by high cash holdings and poor competition from alternatives such as bonds. Nearly 30% of developed country government bonds offer a negative yield and 50% offer a yield lower than 1%. Global equities offer a 2.5% dividend yield.

In capital preservation mode

The absence of economic or earnings momentum coupled with rising risks of recession (although we still do not expect it in coming quarters) warrant shifting to capital preservation. Some profit taking is thus justified in our view, for example on stocks or funds with high volatility, or those stocks close to target prices.