The bull run we’re on has been dizzying. Each week, it seems we see another barrier broken, another record high. We began 2017 looking up at a major market milestone—a day the Dow Jones Industrial Average would close above 20,000. That day occurred on January 25, and now almost a year later, the Dow is hovering near 25,000. While the pace has slowed down some, there’s hardly been any pullback.
We should recognize the markets have had an amazing year, but we should not get caught up in market euphoria or the momentum of the markets. There are several factors driving this record growth, and many of those point back to potential regulatory reforms. Investors are banking on rolling back Dodd-Frank and a tax reform bill that will free up more cash. But, what if those don’t occur? And, even if they do happen, are they enough to continue driving the market? At Beacon, we continue to see momentum being a driving force for the market—and that’s always a scary thing when investors begin to think, “the market’s hot; let’s keep piling more money into it,” instead of looking at the fundamentals behind the growth.
We’ve seen markets behave like this before, and this current run is beginning to take on characteristics we saw in 1999-2000. Currently, the PE ratio for the trailing 12 months is around 25. That’s not yet in the territory of the dot-com bubble of 1999-2000 when it hit 40, but we’re currently in about the 90th percentile historically. Another similarity: the markets are being driven primarily by only two sectors—tech and financial, but a closer look reveals that technology is the biggest winner, up 38.8 percent year-to-date as of this writing.
If we factor in the optimism surrounding tax reform, think for a moment about the tech sector. Many of the titans of the industry—Apple for example—will wind up paying more in corporate taxes if they were to move many of their operations back to the U.S. and pay the proposed 20 percent tax rate. Will they return home if it means leaving money on the table? That’s an additional risk to consider when weighing investments.
With all the market growth taking place this year, Beacon portfolios have participated in the upside but trailed behind major indices; this is to be expected given the heavy weighting in the two leading sectors. Instead of having nearly 25 percent of our portfolios weighted in tech, we continue our philosophy of an equal weight of nine percent across the eleven market sectors. That equal sector diversification approach is our first line of defense for market volatility. We are participating; we are in the market, but we’re not too heavily weighted in any specific sector to avoid exposure to the market bubbles that we have seen both in the 2000s and in 2008 to be so devastating.
Our second line of defense is the stop-loss to limit losses before they become catastrophic. At Beacon, we typically place our stop-loss target at 10 percent of the equity value. Once the equity portfolio drops 10 percent in value, those investments are sold automatically. To put that into historical perspective, in 2008, the start of our last bear market, the S&P 500 dropped 37 percent.
With the markets continuing to sit at record highs, having a strategy that continues to allow market participation while adding this safety net should a correction set in may be a critical strategy to consider and discuss with your clients going into the new year. To learn more about Beacon’s stop-loss portfolio options, contact your wholesaler today!