As the economy keeps growing, the market will sour on the sunny, putting a damper on stocks.
A version of this article ran in the August 2014 issue of MONEY magazine.
The Dow Jones Industrial Average lost another 140 points on Tuesday, wiping out Monday’s modest bounce-back from what had been the worst weekly decline in over six months. All told, the index has fallen 4.1% since it hit a record high on July 16.
This happened despite some pretty good (though not really good) economic data, like last week’s Labor Department report that the economy added 209,000 new jobs in July.
So what’s going on? In short, I suspect the bull market has entered its next—and perhaps final—phase.
Why a change of heart is due. While equities should reflect the health of the economy, there comes a time in every business cycle in which earnings growth—the real driver of stock prices—peaks. S&P 500 profit margins are already at all-time highs. A better job market shows the economy is improving now, but it also hints that wages could rise down the road, weighing on future profits.
At the same time, better-than-expected news may lead the Federal Reserve to stop trying to stimulate economic activity. And that’s a big concern in the final throes of a bull when investors are trying to ride that last bit of tailwind provided by cheap credit.
What works during the bull’s final stage. As risk taking and speculation fall out of favor, shares of big, dominant companies tend to grow in popularity. Today, these big blue chips have another advantage: They’re cheap relative to smaller-company stocks, says Jack Ablin, chief investment officer for BMO Private Bank.
Indeed, the price/earnings ratio for stocks in the Vanguard Mega Cap ETF (MGC), which owns only the biggest blue chips in the U.S., is 16.8. By comparison, stocks in the Vanguard Small-Cap ETF sport an average P/E more than 15% higher.
Where to seek shelter. The natural inclination at this stage is to hide in stable but slow-growing sectors like utilities, since these stocks pay dividends and are likely to fall less in a market downturn.
However, economically sensitive sectors such as energy and tech perform surprisingly well in the last 12 months of a bull, according to Ned Davis Research. So take refuge in a fund like Fidelity Large Cap Stock (FLCSX), which has big stakes in both sectors and has beaten at least 90% of its peers over the past three, five, and 10 years.