3 Ways to Avoid Big Losses When the Bull Market Peaks

The U.S. stock market, as measured by the S&P 500 index, had a stellar first quarter of 2019, up by 13.1%. However, the U.S. cycle indicator developed by Morgan Stanley suggests that stock prices are near a peak, and it suggests 70% odds of an economic downshift within the next 12 months, though not necessarily a recession, Business Insider reports. The table below summarizes the three top recommendations that Serena Tang, cross-asset strategist at Morgan Stanley, is making as a result.

How to Avoid Big Losses When the Market Peaks

• Cut equity allocations, especially to U.S. stocks vs. the rest of the world
• Go heavily underweight in high yield corporate bonds
• Raise cash and increase holdings of long duration U.S. Treasury bonds

Source: Morgan Stanley, as reported by BI.

Significance for Investors

Morgan Stanley's U.S. cycle indicator is based on 10 economic and financial indicators, and smooths the data over 6-month periods. Since April 2010, there has not been a single 6-month period in which a majority of these components have deteriorated, the longest positive streak of this sort since the indicator was developed more than 40 years ago.

"Historically, such an environment of data improvement breadth and depth (with the likes of unemployment rate and consumer confidence hitting extreme levels in recent months) has meant a high probability of cycle deterioration in the next 12 months--after all, what goes up must come down," Tang wrote in a recent note to clients, as quoted by BI. More details on her investment recommendations are presented below.

Equity Allocations. Investor should reduce U.S. equities to 19% of their portfolios and other developed market stocks to 28%. U.S. stocks tend to lag other developed markets in the late stages of an economic cycle.

High Yield. U.S. high yield bonds are just 8% of the new recommended allocation. The return profile is unattractive now and typically deteriorates further in a downturn.

Cash and U.S. Treasury Bonds. Cash is 11% of the new recommended allocation and 10-Year U.S. Treasury Notes are 18%. Morgan Stanley finds that U.S. Treasury bonds tend to outperform as economic cycles age.

Investment grade U.S. corporate bonds are the remaining 15% of Morgan Stanley's model portfolio allocation. Corporate bond funds have been enjoying record net inflows recently, as investors get more cautious, per research by Bank of America Merrill Lynch.

Another defensive alternative for investors is to seek out stocks with bond-like characteristics, such as low price volatility and stable cash payouts. Based on analysis since 1997, only utility and REIT stocks have sufficiently high positive correlations with bond returns to qualify as close proxies or substitutes for fixed income investments, according to this week's edition of Morgan Stanley's Weekly Warm Up report.

Looking Ahead

Four developments offer negative signals for stocks, according to another BI story: a $79 billion year-to-date net outflow from stocks worldwide, per BofAML; soaring short interest on the SPDR S&P 500 ETF (SPY); bearish put options on the S&P 500 are becoming increasingly costlier than bullish call options; and the CBOE Volatility Index (VIX) anticipates greater stock market price swings ahead, themselves normally associated with market downdrafts.

While the bears may be proved wrong once again, all these suggest that preparing for a possible market peak may be an especially prudent course at this time. Meanwhile, small investors are finding it harder to hedge their equity holdings, as liquidity plunges for E-mini S&P 500 futures.