Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity.com: "
Stocks are off to a weak start this year, with the Standard & Poor's 500 index (.SPX) down 6%. The simplest explanation is that, after a 30% gain for the index last year, prices need some cooling off. But there are more troubling signs for those who go looking. The Federal Reserve is scaling back bond purchases that were designed to make borrowing cheap. Emerging markets have been destabilizing. A measure of January manufacturing activity missed forecasts by a mile, whether due to widespread snow and cold or a slowing economic recovery; a snowy February is unlikely to add clarity.
All of this has created an antsy environment for investors, and bad news is being treated harshly. Bank of America Merrill Lynch notes that companies that have recently fallen short of forecasts for earnings and sales have suffered average stock declines of 6% over the following five days. That's the worst number since BofA began collecting the data in 2000.
Investors should resist the urge to bail out of stocks altogether, because predicting short-term market swings is all but impossible. Who in 2000 predicted the S&P 500 would go on to hit 1500, then 800, then 1500 again, then 800 again, and then 1800?
However, investors who are nearing retirement might want to take gains in some of the market's priciest pockets, and hold a 10% to 15% cash cushion. The 1% paid on bank money market accounts won't make anyone rich, but the opportunity cost of holding cash -- the returns investors will miss from stocks and bonds -- might not be all that high, either.
The best 10-year forecast for bond returns is the 10-year Treasury yield. It's 2.6%, or less than half its average of the past half century. And to many on Wall Street, elevated price-to-earnings ratios suggest that stocks are poised for single-digit returns from here. Bob Doll at Nuveen predicts 6% to 8% returns over the next decade. John Hussman of Hussman Funds expects average returns of zero for seven to 10 years.
For investors looking for something to sell, don't start with emerging market shares. While they could continue to be subject to plenty of short-term volatility, they're also priced for long-term outperformance. The MSCI Emerging Markets index underperformed its U.S. sibling by 35 percentage points last year. And based on a 10-year average of earnings, the EM index is only half as expensive as the U.S. one.
Start with U.S. shares, especially those of small companies. Small companies tend to grow faster than large companies, and so tend to fetch slightly richer valuations. Historically, the average premium has been 4%. Now it's 23%, judging by 2014 price-to-earnings ratios for the S&P 500 and S&P 600 indexes.
Consumer stocks offer two reasons to take gains. They're a bit pricey, at premiums of 17% for companies that sell discretionary items and 9% for companies that sell staples, versus the broader 500 index. They're also showing some cracks. The two sectors are the only ones for which both earnings and sales reports are tracking below analyst estimates for the fourth quarter. Again, maybe it's just weather, or maybe shoppers are pulling back.
The third category to take gains from isn't so much a sector as a club: darling stocks, mostly consumer-facing and mostly dot com companies that have ridden the market's recent rally to frothy valuations. Fast-growing companies deserve premium prices, but if the argument for a stock's price feels strained – "Twitter (TWTR) is only 25 times earnings before interest, taxes, depreciation and amortization based on 2017 forecasts" -- it's probably time to cash in some gains. Amazon (AMZN), Facebook (FB), Netflix (NFLX), Chipotle Mexican Grill (CMG) should all continue to thrive from here, but their shares are well over 30 times next year's earnings estimates and might not benefit from the tailwind of raging stock-market momentum this year.
Finally, bond investors should consider trimming their junk bonds and funds. Junk gained more than 7% last year while the Barclays Aggregate index lost 2%. Barron's colleague Michael Aneiro points out that the spread between junk and Treasury yields recently fell below four percentage points for the first time since the summer of 2007. Partly that's because default rates are exceptionally low. But if stocks tumble or the economy falters, investors will dump junk long before the default rate rises.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.