Is the bond market too bearish or the equity market too bullish?

Trying to time the market has proven to be quite costly for U.S. retail investors. Take this year, for example, where, according to JPMorgan Chase & Co., they are on track for their fourth straight year of underperformance versus the S&P 500. I was shocked to see that the average retail investor is up just 3.7 per cent year-to-date, compared with the S&P 500, which is up double digits and on track for its best election year performance in 88 years.

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I can only believe that many thought the rally in 2023 was temporary and went to cash or stayed uninvested anticipating a correction. Well, one didn’t happen, and we experienced one heck of a run instead.

Looking ahead, we think this market should continue to move higher, as long as there is ample liquidity. In addition, the Bloomberg U.S. Financial Conditions Index — which tracks the overall level of financial stress in the U.S. money, bond, and equity markets to help assess the availability and cost of credit — has rarely been looser when looking back at the past couple decades, favouring more risk-on investing, such as stocks versus bonds.

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Additionally, with the upcoming change in the U.S. government, there are many positive factors that could push U.S. markets that much higher and there is no shortage of market strategists telling you that. There are many voices saying, “You had better get on board, otherwise you will be left behind and miss out on another year of strong returns.”

But few are asking what happens if they are wrong and markets suddenly correct?

I would suggest that for those contemplating going all in on equities, there is a time to add risk and a time to reduce it. The equity risk premium, which is the difference between the 10-year Treasury yield and the S&P 500 yield, is now negative, something that also hasn’t happened in 22 years. This means investors are not receiving a premium but rather paying to take on risk.

Another way of looking at it is by asking if the bond market is too bearish or the equity market too bullish? In time, one will eventually be proven right and the other wrong.

Not helping matters is you have a U.S. stock market that is overly concentrated, as evident by days like last Tuesday where one stock, Nvidia, contributed 65 per cent of the S&P 500’s returns. Over the past year, Nvida accounted for one fifth of the S&P’s gains, more than all of the other Magnificent Seven stocks combined. To put this into perspective, the world’s second-largest stock, Apple, contributed a mere three per cent.

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Then on a multiples basis, the Top 10 S&P 500 stocks’ forward price-to-earnings ratio (P/E) hit approximately 30 times, much higher than the 25 times seen during the 1990s Dot-Com boom.

This creates a conundrum for those underweight equities, as staying in cash isn’t helpful either, especially with interest rates falling. Moving to government bonds could also prove risky, especially considering the amount of debt issuance required by governments like the United States running monster-sized deficits. Then you have corporate bonds spreads at low levels not compensating for risk.

In this environment, we’re staying invested but layering in some risk-management strategies, which include a healthy cash position, albeit not overdoing it. We have replaced our bond allocation with a diversified strategy encompassing structured notes with deep downside barriers and high single digit coupons being paid out on a monthly basis.

This is complemented by some Canadian dividend companies backstopped with healthy balance sheets, broader U.S. equity indices but with embedded hedges to protect against concentration risk, rounded out with some commodities exposure, and private equity.

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Essentially you don’t want to try to time the market but always be in the market so that you don’t miss out on strong years like 2024. However, we recommend doing so through proper good old-fashioned portfolio management that includes things like diversification and other strategies that will protect you when markets unravel, as they eventually do.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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