The S&P 500 just had its best 12-month performance ever — up 80% as of the end of March. But the bull market may be entering a new phase as it turns two years old — an investing regime that requires a bit more defense.
"It's definitely hard to say that we're going to see 80% gains in the second year. But we think that it's even harder to say that the market is going to rally with the momentum it's had recently — for a few different reasons," says Callie Cox, senior investment strategist at Ally Invest, on Yahoo Finance Live.
She explains that over the last three quarters, we've been in a "low expectations" market — one fueled by big earnings and economic beats. "[R]eal earnings growth has beaten estimates by 10 percentage points because estimates were that low. And going into Q1, estimates are high again ... [W]e think investors could get a little confused as they see real earnings growth come in that's not quite as high compared to estimates... So it's really like a mind shift that we're dealing with," says Cox.
This is not a reason to get bearish — only to tame expectations for the next year of returns. According to Ally Invest calculations, there have been nine times when the 12-month rolling return on the S&P 500 was 30% or more since 1950. According to Yahoo Finance calculations, these periods yielded a median gain of 34% and an average gain of 40%. In the year following these returns, all were positive (and no bull market has ever ended in year two, notes Cox). However, profits were more muted, with a median return of 11% and average return of 13%. The S&P 500 is already up 9.7% this year.
"[I]t's typical for the bull market to lose a little bit of steam going into year two. And that's going back to the low expectations, high growth kind of thing. Expectations start rising and makes it harder for the market to ... beat everybody's expectations. And that leaves a greater chance for disappointment. And to be clear, again, we're not calling for doom and gloom. We just think the market is due for a breather up in the next quarter or two," says Cox.
If stock market returns are to come back in line within historical norms, Ally recommends gaining exposure to more defensive sectors, such as utilities and consumer staples.
"We've seen less of the recovery gains go to those sectors. And those are the types of sectors that can do well when the market kind of stagnates or if it sells off. Those are defensive. So investors typically rush to those areas," she says.
The above chart shows that since the interim market bottom on March 4, the S&P 500 has gained 9.5%. The performance of the S&P Select Consumer Staples SPDR Fund (XLP) nearly matches it at 9.2%, and S&P Select Utilities SPDR Fund (XLU) surpasses it, clocking in at 10.6%.
Cox doesn't believe investors should count out tech (XLK) either, which staged a big comeback last week after lagging most of the year. "We're feeling a little less optimistic about tech, just because it's gained so much. And in a high growth environment, growth stocks like tech stocks typically don't do as well. But then, again, the market has surprised us a lot over the past year or so. We are optimistic on tech longer term," says Cox.
This article originally appeared on Yahoo! Finance.
