Get ready to keep your eye out for bubbles.
The U.S. economy is just past the midpoint of its boom cycle and will grant at least an additional two years of a bull market. But investors should watch for frothiness to avoid a bubble bursting at cycle's end, according to recent research from Montreal's Pavilion Financial Corp.
As price-to-earnings multiples and profit margins rise beyond historical averages, the investment services firm says, history warns that the market is likely to tumble into recession within two to seven years.
While that's not a problem for short- and mid-term buyers, it's a stern warning for buy-and-hold investors. They should consider rebalancing in the coming years to avoid excessive pain.
"We still think the equity market has legs," says Pierre Lapointe, Pavilion's head of global strategy and research. He points out that U.S. stocks are up 19 per cent over the past year, but over seven years, as profit margins are squeezed and P/E multiples inevitably regress, "the buy-and-hold methodology might not give expected results."
That time could come as soon as two years from now, depending on how much longer the U.S. Federal Reserve doles out stimulus, Mr. Lapointe says. Five years have elapsed since the economy started rebounding in 2009, which means another two would cap a seven-year cycle. On average, the last three economic cycles each lasted about seven years.
As the cycle comes to a close, Mr. Lapointe says, investors should look for a bubble and shuffle their portfolio accordingly.
"But if you incorporate a more tactical approach" than simply buy-and-hold after that, Mr. Lapointe says, "you might actually do much better."
Ryan Lewenza, a North American equity strategist with Toronto-Dominion Bank's wealth management division, says the next two years will be good for stocks, too, with another 12 to 18 months driven by corporate profits. But that will come to an end, and since interest rates will eventually rise, too, a recession is all but guaranteed in a few years.
Buy-and-hold investors will still make money in the long-term, Mr. Lewenza says, projecting returns of 8 or 9 per cent over the next decade. "You'll have pullbacks, you'll have recessions, but on a secular basis, we're in for above-average rates of return."
But playing the market strategically will bring in even more dough. Investors should rebalance their portfolios next year, he says, de-emphasizing cyclical sectors such as financial, IT and industrial equities and beefing up on high-quality defensive stocks such as Wal-Mart and McDonalds, which weathered the last recession well.
For safety's sake, he recommends buying put options on S&P 500 or S&P/TSX stocks when the market starts to look frothier, likely some time in 2015. Weaning off equity exposure and buying bonds isn't a bad idea either, he says.
The idea of buying and holding leads to too much comfort and complacency, says Vincent Delisle, an investment strategist and managing director with the Bank of Nova Scotia's portfolio strategy group.
"If you believe in cycles, you have to open up to buying and selling, not buying and holding."
He, too, suggests the U.S. has passed the middle of its economic cycle, with only a couple of years left before a bear market rears its head, as the Fed tapers its bond purchases and higher rates loom.
People too often divide investing strategy into the false dichotomy of buying and holding versus day trading, Mr. Delisle says, whereas in today's environment, the middle ground proves strongest.
"If you're buying a sector, or a stock, are you really going to hold it for 20 or 40 years just because that's what paid off in the 90s?" he asks.
"There are ways to be more proactive, more tactical about asset mix and sector strategy. Determining where you are in the cycle is the first step, and then it's which areas you want to overweight and underweight."