Alicia Levine: It’s Time to Play Defense

Alicia Levine is chief strategist at BNY Mellon Investment Management.

KIPLINGER’S: What’s your outlook for U.S. stocks?

Levine: That’s a simple question but a complicated answer. If the market can hold the lows of 2018, at about 2550–2600 on Standard & Poor’s 500-stock index, then I see the market moving higher. But if we breach that level, then I see a further 10% downturn; that would be a 20% decline from the highs. It’s been a bull market for 10 years, and the market has pretty much gone straight up. When a market has increased to this extent for this period of time, the shakeout can be unpleasant.

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And if the market muddles through? If the level does hold, then I see another 15% gain over the first part of the year. We could see 3100 on the S&P 500 sometime in 2019. If you’re a trader, we feel comfortable buying here. But for investors, the risks are stacked on the downside. If you put fresh capital in, you’re putting it in a 10-year-old bull market with rising interest rates and slower economic and earnings growth rates. The message you’re getting from the market is that you’re closer to the end than the beginning. The bull market could limp along another eight to 12 months. But nothing goes up forever. It’s time to think about protecting your capital and getting more defensive.

What should investors watch out for? We could shoot ourselves in the foot with trade, or the Federal Reserve Board could over-tighten. There are concerns that the projected growth rates in corporate earnings are not feasible. Most analyst estimates are too optimistic—2018 was the opposite, with several quarters of earnings that analysts underestimated. But in 2019, we’ll go back to the old normal of overly optimistic earnings expectations. Over the year, I expect those to come down. We just heard in corporate earnings conference calls that companies are facing higher raw materials costs, higher labor costs and tariffs—this is where the trade war comes in. If companies don’t pass those costs on, they will have to eat them, and profit margins that are now expected to rise will have to come down.

How can investors position themselves more defensively? Make sure you have an allocation to fixed-income investments. I think fixed income could be at least 40% of a portfolio. Because rates are rising, investors should consider short-term bonds, which are less sensitive to interest rate moves. And by the way, with the Federal Reserve Board raising rates, cash is now an asset class that investors should allocate to. It’s really important to have dry powder, especially if it’s going to pay you something. If there’s a big decline, you can take advantage of it. Risk-tolerant investors can keep up regular contributions to stocks and use sell-offs as opportunities to lower their average cost.

Which stocks do you favor? We’d be very cautious on growth-oriented stocks. We prefer value-priced stocks; there’s a nice entry point for value stocks now. I’m interested in health care stocks, but not pharmaceutical firms or biotech—they’re under threat of regulation. Financials, particularly money-center banks, have gotten really beaten up and are good values now. We like some tech companies, but not the FAANG stocks. In general, focus on solid companies with good cash flow and not a lot of debt. Make sure companies can pay their dividend and service their debt.

How will politics affect the market? The first two years of the Trump presidency were about deregulation. The next two could be about further regulation. We could see it in biotech, pharmaceutical stocks and large-company tech. That’s a negative for stock performance, and you’re going to wind up with a lid on the price-earnings ratios for those stocks. There’s an argument that drug stocks are cheap enough now, but you shouldn’t be surprised when both Democrats and Republicans have an interest in regulating prices. With Democrats in control of the House, the Affordable Care Act is safe; that means hospital companies in general and managed-care providers focused on Medicaid services should do well. Trump will be interested in an infrastructure spending bill, and so will Democrats—I can definitely see this happening. Construction companies should do well.