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Of Mutual Interest: After months of calm, a warning sign?

Posted August 31

— It's been a remarkably calm year for the stock market. Did an alarm just go off?

Stocks have risen to records this year, buoyed by steady growth in the U.S. economy, improvement in formerly-struggling international economies and a resurgence in corporate earnings. As of Wednesday, the Standard & Poor's 500 index is up almost 10 percent this year. That's about equal to its typical full-year gain and better than many experts had predicted.

But in August the market hit a speed bump: stocks took two weeks of losses as investors worried about rising tensions between the U.S. and North Korea, terrorist attacks in Spain, mounting challenges to the Trump agenda of tax cuts and infrastructure spending, and poor results from some big-name U.S. retailers. To say the least, it was a lot to digest.

In historic terms, the market's losses over those two weeks weren't huge. The S&P 500 fell a bit more than 2 percent as industrial and energy companies slumped, and the small-cap Russell 2000 dropped 6 percent. It was the worst period for the market this year, and the Chicago Board Options Exchange's volatility index, a measurement of how much volatility investors expect to see, reached its highest level in months.

"If we see further spikes in volatility that will not surprise us," said Joe Davis, chief global economist for Vanguard. "The headline or the catalyst may, but the ultimate result won't."

While stocks later recovered some of their losses, geopolitical tensions and the effects of Tropical Storm Harvey continued to weigh on the market after that. And the turbulence comes right before the worst month of the year for stocks: on average, the S&P 500 falls 0.5 percent in September.

The current bull market is eight years old, and Wall Street has been debating how much longer it can last. There's little reason to expect another drop in corporate earnings or a recession, and analysts are fond of pointing out that bull markets don't simply die of old age. Still, nothing lasts forever, and Davis says he thinks investors should get into a more defensive position now instead of waiting for the exact right moment to pull back from stocks.

"I think the next year or two is going to be a more challenging environment for investors than any time in the last eight or nine years," he said.

Davis is preaching caution because stock prices are at such high levels. With bond yields and interest rates low and corporate earnings rising, stocks are not only higher than ever, their price-to-earnings ratios are abnormally high. Davis encourages investors to look away from U.S. stocks and put some of their money into other types of assets. He has a more positive view of stocks in non-U.S. markets, which in general are less expensive than U.S. equities. He also feels investors should diversify by adding government bonds and other low-risk assets to their portfolio and avoid reaching for high-yielding assets.

These days, stocks and bonds practically move in opposite directions: when one is up, the other is down. That makes bonds a good way to diversify.

"One of the reason yields are so low is the diversification value of bonds today is probably the highest it's been in 25 years," he said. "There is considerably more risk in the equity market than in the bond market."

Like many market watchers, Davis thinks it's inevitable that this calm period is going to end. Whether that happens next week, when many traders return from summer vacation, or later on, Davis suggests investors prepare now, because historically investors make worse decisions if they wait for the market to weaken to take action.

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