How to React Wisely to New Market Milestones

Stock Market Up

Stocks have done well in recent years, and the result is stock market indices at record levels. May 22nd was the 10th time so far in 2015 that the S&P 500 index of large US stocks has closed the trading day at its all-time high. How should you react to this spate of new milestones?

Despite the common tendency for many investors to assume that “what goes up must come down,” historically stock market highs have actually been a bullish indicator. Over the past 40 years, the average one-year gain for the S&P 500 index following a new all-time high is about 2.5 percentage points greater than the overall average one-year gain. So selling stocks simply because the market reaches a new high probably isn’t wise.

But using a new market high as a buying opportunity isn’t necessarily a good idea either. When one particular asset class (such as US stocks) performs well for an extended period of time, this asset class often grows to become a larger portion of your portfolio. This change can substantially alter your portfolio’s riskiness, even if you haven’t intentionally reallocated your investments. When this occurs, buying more of the asset class that has recently done well will just further skew your portfolio’s allocation.

Instead of using a market milestone to try to guess whether the streak will continue or reverse, a better idea may therefore be to use the opportunity to assess whether the market’s movements have distorted your portfolio. If they have, rebalancing back to the risk level you’re comfortable with may be the best action to take.

Should You Worry About Rising Bond Yields?

10Y US Treasury Yield 4

2015 hasn’t been a great year for bonds. While US stocks have returned more than 4% since the start of the year and international stocks have done even better, US investment grade bonds are essentially flat. And in the last few months they’ve actually lost money as bond yields have risen (yields move in the opposite direction of prices, so bonds lose value when their yields rise). Is this the start of a surge in bond yields, or simply a short-term blip?

To answer that question, the first thing to note is that the recent rise in yields (at least for US bonds) hasn’t been especially dramatic. The yield on 10-year US government bonds has risen from below 1.7% at the start of February to over 2.2% this week. That increase pales in comparison to the jump from around 2% to around 4% in 2009 and the increase from 1.7% to around 3% in the summer of 2013.

But could the recent rise in yields just be the start of a larger trend? Unlike in 2009, when fears of a global financial collapse were abating, or 2013, when comments by Ben Bernanke sparked fears about the end of the Federal Reserve’s quantitative easing program, there’s no clear economic explanation for why bond yields have risen in recent months.

Government bond yields typically rise because of factors such as an improving economic outlook, higher expected inflation, and (in some cases) the Federal Reserve raising short-term interest rates. But economic statistics suggest that US economic growth has slowed, the inflation rate has remained low, and the Fed is no longer expected to start raising interest rates early this summer, as many economists expected at the start of the year.

The lack of a clear economic explanation suggests that the recent rise in bond yields is likely more of a short-term blip than the start of a larger trend. For investors who are concerned about a continued rise in yields, one way to reduce risk without decimating your asset allocation is to shift your bond holdings toward shorter-term bonds. But bond yields can stay low for a long time, and there’s no economic evidence that the era of very low bond yields has ended.

The Implications of the UK Election

UK Election

The United Kingdom has its general election on May 7th, and the election outcome could be intriguing for a number of reasons. Typically British elections are dominated by the Conservative and Labour parties, with the Liberal Democrats far behind in third place and all the other parties barely winning any seats in parliament. This time the Scottish National Party (SNP) is expected to overtake the Liberal Democrats as the third-largest party in parliament, and a slew of smaller parties such as the UK Independence Party could upend the vote. Beyond the political storylines, however, the election outcome could have implications for your portfolio.

Last September, Scottish voters narrowly rejected a referendum on whether Scotland should break away from the United Kingdom and become an independent country. A “yes” vote on independence likely would have hurt many British companies by creating uncertainty about what currency Scotland would use and how a newly independent Scottish economy would be managed and regulated. But the rejection of the referendum didn’t put the independence issue to rest. Support for the SNP, which strongly backs Scottish independence, has surged over the past 7 months. Success by the SNP in the upcoming election would increase the chances of another independence referendum.

A promise that Prime Minister David Cameron made could have an even more widespread effect on investors’ portfolios. In 2013 he vowed to give British voters a referendum on whether the UK should remain part of the European Union. Such a referendum won’t necessarily occur: the Conservative party would have to win the upcoming election and be able to form a government with only coalition partners who also agree to the referendum. But if it does occur, the political and economic uncertainty created by such a referendum could adversely affect not only British companies, but also companies around the world that operate in the UK or trade with the UK.

Many of these effects from the election may not occur for a while. Cameron’s proposed referendum, for example, wouldn’t take place until 2017, and much could change in British politics before then. But the general effect of the election for investors could be to increase the impact of political risk on financial markets. So far this year, despite conflicts in the Middle East and drama surrounding the Greek government’s finances, markets have largely shrugged off political risks. The UK election has the potential to change that.