Are We Climbing the Wall of Worry or Is It Time to Be Cautious?

Bloomberg ran an article last week headlined “JPMorgan Says Clients Are Clinging to Risk Despite ‘Palpable’ Anxiety”:

At JPMorgan Chase & Co., the bank’s clients are in the throes of that conflict. Despite concerns, they’re unwilling to stray from benchmarks and take on defensive trades, according to John Normand, head of cross-asset fundamental strategy at the U.S. bank.

“The sense of anxiety is more palpable in client discussions and in the news flow than it is in investor positioning,” Norman wrote in a Thursday note. “As much as they sympathize with late-cycle risks, they cannot run such tracking error for several quarters to pre-position for a more stressed environment.”

It is often said the stock market climbs a “Wall of Worry.”  There are always things to worry about that could derail the market or the economy, yet the market over time tends to push higher despite these concerns.

Is the anxiety expressed by JPMorgan’s clients merely the Wall of Worry in effect?  The economy is quite strong and there is every reason to think this will push the market higher, yet previous crashes are still salient in investors’ minds, and it is natural for investors to believe we are overdue for significant decline.  Such a mix of strong fundamentals and cautious sentiment looks exactly like the Wall of Worry.

Nonetheless, their anxiety is not expressed in positioning.  Investors are sticking with benchmarks and taking on risk despite their concerns.  As Bloomberg notes, investors are “loading up on cyclical stocks versus defensive ones” and chasing yield buy buying “short-duration corporate bonds — including some of the riskiest junk debt.”

The combination of anxiety and risky positioning may lead investors to quickly sell if a correction gets going.  We saw this happen earlier in the year (briefly) when the stock market declined by over 10% from its all-time high in just nine days, one of the fastest such moves in history.  Since then the market has resumed its rise.

I am particularly concerned that investors are unwilling to risk underperforming benchmarks by exercising caution and instead are staying with the herd despite the risks.  This sets up a situation where the market may rise steadily for a time, but volatility may return with a vengeance when investors least expect it.

Does this mean a correction or bear market is imminent?  Not necessarily, but I do think volatility will return, perhaps soon.  Here are some things investors need to be thinking about now:

• If you are uncomfortable with the risk in your portfolio, make changes now.
• Know what you own and why it is in your portfolio, so you have the confidence to hold through volatility.
• Exercise caution, particularly with leveraged securities or cyclicals highly dependent on a strong economy. If you have enjoyed gains in these types of positions, consider reducing exposure.
• Be selective in new investments.
• Beware the risks of benchmark-hugging and crowded trades, particularly with the rising popularity of index investing as many “buy and hold” investors may head for the exits all at once.
• Plan now for what you will do if we have a correction – will you hang tight? Do you have cash to deploy as the market declines?

We cannot know when volatility will return, but the time to plan is now.