Stocks Near All-Time Highs: Where Do We Go From Here?| Franklin Templeton

As stock markets approach all-time highs, Franklin Templeton Investment Solutions believes that signals of overbought stocks have emerged. They look at the forecast returns of stocks after hitting or near all-time highs, and what those results could mean for the allocation between stocks and bonds.

Key points:

• As stock markets approach their all-time highs, a tension between momentum indicators and contrarian indicators naturally arises. We find it important to examine these indicators to refine our tactical views.
• As overbought stock signals emerge, our optimism may be moderated, at least temporarily.
• We have reduced our preference for stocks and now have a neutral view between stocks and bonds. Our macroeconomic outlook remains constructive and we view a correction in stock prices as an opportunity to become more optimistic.

Stocks close to all-time highs

Stocks are once again near cyclical highs. Is this a good or bad thing for asset allocators? With stocks near cyclical highs, the momentum clearly supports risky assets, in our view. However, it appears that much of the good news is priced in, and contrarian indicators suggest that allocators should be more cautious. Which perspective is better?

As usual, we turn to data as a starting point to answer the question above. For starters, stocks reaching or near cyclical highs is not as rare a phenomenon as it may seem. Since 1973, stocks have reached all-time highs 14% of the time.¹ Additionally, they are within 5% of all-time highs 46% of the time (see Table 1).²

Although these metrics represent stocks at similar points in time, we observe a significantly different pattern in terms of returns. When stocks reach all-time highs, forward stock returns tend to be lower. However, if we expand the sample to include all periods where stocks are within 5% of all-time highs, then we see forward stock returns consistent with the historical average.

We see similar results when looking at technical indicators that measure investor sentiment. When the relative strength index (RSI) is above 70, this is generally considered to signal overbought conditions; lower forward stock returns follow on average. However, if we zoom out and include all periods where stocks stay above their 40-week moving average, then stock returns tend to be slightly better than historical averages (analogous to our previous example when stocks are close, but not at historical level). peaks).

Chart 1: Technical indicators and forecast stock returns

How can we make sense of these mixed results? Overall, these results support the classic saying: “the trend is your friend.” As stocks move higher, we want to recognize that positive momentum has generally been a favorable factor for risk-taking. However, it also seems clear that stocks can be temporarily overextended during a bull market, and we believe it may be beneficial to tactically reduce exposure when this occurs.

As stocks have recently reached all-time highs, we have adjusted our risk orientation; we now have a neutral preference between stocks and bonds. We remain optimistic about the stock market environment, with a generally favorable macroeconomic outlook and positive dynamics in company fundamentals. However, sentiment indicators suggest that stocks may have limited upside potential in the near term. It may be wise to favor a more balanced (neutral) outlook between stocks and bonds when this occurs, seeking to reestablish risk preferences in the event of even a moderate stock downturn.

Exhibit 1 Methodology

Statistics for this exposure are calculated using weekly data measuring the S&P 500 Price Index. Returns are calculated on a forecast basis, by measuring forecast weekly returns and annualizing the data for each plan.

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1. Sources: Sources: Bloomberg and S&P. Calculations performed by Franklin Templeton Investment Solutions. The indices are not managed and you cannot invest directly in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future performance. See www.franklintempletondatasources.com for additional data provider information.

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