Investors are showing a bit more willingness to step out and take on a bit more risk with equities, despite the worrying headline du jour, whether about the U.S. budget, Europe’s continuing woes, or something new.

So is it safe? Reports still lurk of wary investors young and old sitting on substantial cash cushions. But Wall Street strategists have issued waves of reports to reassure the skittish.

“You’ve got a ton of arguments supporting higher stock prices, you’ve got fundamentals improving, you’ve got valuations improving, and you’ve also got a dissolution of the great fears that pushed investors into safer assets,” said David Roda, regional chief investment officer for Wells Fargo Private Bank.

The stampede back to equities makes sense, according to Roda, as the safe assets, including cash and government bonds, have been yielding meager returns.

“If you think about the ability to produce income, fight against inflation, or even the stability of traditional bond portfolios – that’s all out the window. Now if a 10-year bond moves up 1% in yield, it will fall by 8% in price. That safe asset has become a risky asset,” Roda said. “We’re not surprised to see a migration back to investing in investments that have a better change of meeting long-term goals…The fundamentals still support the market in the long term.”

Nevertheless, while many Wall Street strategists agree that it’s time to take a bit more risk, they are divided on where they see opportunities.

Weighing the Risks

“Simply put, ‘risk isn’t as risky’ and ‘safe isn’t as safe’ as it used to be,” Jim Paulsen, chief investment strategist at Wells Capital Management, wrote. He notes that in the last year, lower-risk stocks have seen their price volatility relative to the overall market (beta) rise.

The beta of riskier stocks has fallen. In fact, the gap in the beta of the S&P 500’s three most defensive sectors - utilities, consumer staples and healthcare - and the three most cyclical, or aggressive sectors – consumer discretionary, industrials and materials - has narrowed to a level not seen since the stock market bottomed in early 2009. This means all the investors who loaded up on defensive stocks to weather the choppy markets are not getting as much protective bang for their buck as they thought.

Certainly, defensive stocks are nearly always less risky than cyclical stocks. But, the amount of relative protection the defensive stocks give a portfolio changes over time. For instance, in early 2012, the gap between defensive and cyclical stocks was about 0.65. This quarter, it was only about 0.35.

In practical terms, that means these defensive stocks are giving investors some of the wildest rides of the whole recovery, while cyclical stocks are gyrating less than they have since the market hit bottom in early 2009. Add to that the fact that most cyclical sectors have beaten defensive sectors in total returns recently.

What’s more, Paulsen notes that the stock market has typically performed well when defensive stock price betas are high relative to cyclical stock price betas.

“Investors may want to consider this changing beta relationship in structuring portfolios and perhaps lift the weightings of cyclical stocks,” he wrote. “So far in this recovery, when defensive stock betas have risen relative to cyclical stock betas, the overall S&P 500 Index has tended to rally.”

What Lies Ahead

But no view is unanimous. The cautious camp worries that continued low interest rates aimed at stimulating the economy are driving today’s returns down for the next several years.

“We definitely believe returns will be lower than the long-term average,” said Gene Goldman, vice president of research at the Cetera Financial Group. He figures the S&P 500 is looking at several years of 4% to 6% returns, far short of the 9.5% average the large cap index has posted since the 1920s. But still, he likes stocks better than cash, which he notes is paying less than inflation rates, leaving investors in the hole. Goldman has been telling advisors and their clients to stick with defensive large caps, and to favor dividend-payers.

Back in the cheerier camp, the brain trust at S&P Capital IQ agrees with Paulsen and Roda, advising investors to position their portfolios to overweight cyclical stocks and underweight defensive shares.

Stocks also look good from a historical standpoint. The S&P 500 climbed 5.4% in the year through January 25, the 18th best performance since 1900, notes Sam Stovall, chief equity strategist at S&P Capital IQ.

The Stock Trader’s Almanac suggests that bodes well, saying, “As goes January, so goes the year.” In fact, in 12 of the last 15 post-presidential election years the S&P 500 followed January’s lead, notching gains for the year, said Jeff Hirsch, editor-in-chief of the Stock Trader’s Almanac. Overall, January has successfully predicted the fate of the S&P 500 for the year 81% of the time since 1900, according to Stovall. Conversely, every January that saw the S&P 500 end in the red preceded a new or extended bear market, a flat market or a 10% correction, Hirsch noted.

Savvy advisors can often use a little sector knowledge to great advantage, Stovall says. Since 1990, an equal ownership of each of January’s top three S&P 500 sectors made for a 12-month annual compound growth rate (CAGR) of 8.2% versus 7.5% for the broader index. Plus, January’s winning portfolio beat the market 61% of the time. This year’s top three sectors were consumer discretionary, energy and health care.

Both Stovall and the equity strategists at Wells Fargo Advisors reckon the S&P 500 will end the year on a high, although they expect continued volatility.

Tom Roseen, senior analyst at Lipper, agrees that volatility is likely, and says those who want to venture back in should use falling prices as buying opportunities. But he adds that the cautious are not without reason. “We’re near new highs, and there will be pullback,” he said. He added that investors should be prepared to ride out a rocky road, with losses of perhaps 5% to 10%.

One strategy that Brian Pultman, a St.Louis-based advisor for Wells Fargo, said that he uses to help give clients confidence is dividing their portfolios into buckets. With that strategy, one third goes to safer investments like money market funds, CDs and bonds to give clients peace of mind; another third is earmarked for growth, with a diversified portfolio of stocks, including dividend-payers; and the final third goes to more tactical investments like annuities or balanced funds, where the client gets to share in the profits when markets rise, but also gets protection when they fall.

“We try to keep them focused on the longer-term,” Pultman said.

Register or login for access to this item and much more

All On Wall Street content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access