NEW YORK, April 10, 2018 /PRNewswire/ -- In a webcast on the state of U.S. and global markets, two of Legg Mason's QS Investors senior professionals asked whether this is a time for investors to remain committed to U.S. stock markets – or is it time to allocate in other directions, such as smart beta products?

"Everyone is asking, 'Should investors stay invested, or should they look for other opportunities at this stage of the market cycle?'" posed Michael J. LaBella, a portfolio manager with Legg Mason affiliate QS Investors. "Bull markets used to be a lot more fun."

As the bull market turns nine, QS Investors' investment managers reported that they expect economic growth to slow in 2018. Their main concerns are interest rate headwinds; trade policy uncertainty and concerns over a potential "trade war;" and softening in some global economic numbers.

What should investors consider? To capture opportunities in value, Legg Mason's analysts emphasized it best to think outside the traditional style box and diversify their value buckets.

"Defensive equity income strategies are value-oriented and could outperform due to the slowing investment cycle and cheaper equity valuations," Mr. LaBella said. "If inflation increases, high-sustainable-yield companies tend to outperform. In down markets, they offer the potential for smaller drawdowns, unlike traditional value strategies that buy cheap book/price and earnings/price stocks."

For sector positioning, Mr. LaBella reported that, "We like the cheaper utilities, consumer staples and consumer discretionary. We are tip-toeing back into energy and healthcare."

Financial advisors are embracing more outcome-oriented approaches over the traditional value/growth style box. In a Legg Mason survey of financial advisors, 67 percent reported interest in moving to outcome-oriented approaches, while only 19 percent preferred traditional style boxes. This could be one reason that "smart beta" strategies have been rapidly gaining assets.

Tracking the moves made by and expected of the U.S. Federal Reserve¹ also loom large.

"Chairman Powell will likely be very status quo, as he gains nothing by rocking the boat," Mr. LaBella observed. "That likely means three or four interest rate increases this year, but it will be data dependent so remains a little uncertain. The market priced in one so no reason not to do it."

Going back to the lows of March 2009, U.S. stock markets are up well over 300 percent. Yet until a few months ago, this long bull market rally was called "the most hated in history." Why?

"A bull market is essentially a macroeconomic market rally that does not have a 20 percent correction," Mr. LaBella noted. "The last two rallies, from 2002 to 2007, coincided with the real estate bubble. The two bull market rallies in the late 1990s coincided with the dotcom bubble. This rally just became the longest bull market expansion in U.S. history, up over 320 percent. Yet there wasn't a lot of euphoria investing in it like other bull markets, where investors were excited about the economy in some new way, such as with the real estate boom, or technology."

"As the expansion ticks on, the market narrows and becomes more concentrated," he said. "The top five companies in the index are all technology companies, if you include Amazon. They have contributed enormous amounts of return to the S&P 500: close to 25 percent. Amazon is contributing close to 40 percent of that. This tends to happen as markets age. This bull market has been very good for large cap U.S. growth equities, but everything else has been left behind."

It has not just been stocks, Mr. LaBella observed, but has been true for investment style as well. From the start of this bull market, growth has significantly outperformed value. That has been the case in four out of the last five years, and last year it did so by the widest margins since 1999.

"And it's not just stocks or style, but we see similar trends in the U.S. versus international," he noted. "In seven of the last 10 years, the U.S. outpaced international markets. That's a clear break from the prior 10 years, going back to the mid-2000s. What's driving that? In terms of the market recovery after the financial crisis, the U.S. more aggressively engaged in fiscal and monetary stimulus, before Europe and Asia did, but this has started, slowly, to potentially reverse."

Last year emerging markets outperformed the U.S., and investors are asking: will it continue?

"When we think about valuations, in this very low interest rate environment, are markets expensive or more fairly priced?" Mr. LaBella said. "Certainly, no claim can be made that things are cheap. But investors are not particularly concerned: about the length of the bull market; or how potentially concentrated it has been by style, region or valuation; or the extraordinarily low period of market volatility. You have to go back to the 1960s to see similar levels of volatility."

"Volatility is not a bad thing. It could make investors take on more risk or move into areas of the market they potentially don't have the risk tolerance for. We saw a little bit of that in the last couple of weeks, where we saw volatility return to the market. Investors are going to have to embrace that and do things to make sure they can live with this level of volatility."

Investors may need to stay invested to avoid some of the largest retirement shortfalls in history.

"People are living longer, Mr. LaBella said. "When the modern retirement system was set up in the 1930s, average life expectancy was 61. Now average life expectancy for women is over 80, for men over 76. A couple that's 65 has a 90 percent probability that one will live past 80, and a 50 percent probability that one will live past 90. People did not plan for that, nor did our system. We have not made material changes to our retirement system in 50 years."

"It has not been helped by the fact that growth has been decreasing," he continued. "This 300 percent-gain bull market in equities has been powered off relatively low GDP² growth. Going back to the 1960s, average GDP growth tended to be over three percent. In the 1980s and 1990s, it was between three and four percent. Since the Financial Crisis, the average is 2.2 percent."

In helping clients achieve their goals, asset allocation is an increasingly important consideration.

"The economic backdrop is good, and we are actually still fairly constructive on equities," said Adam Petryk, Head of Multi-Asset and Solutions with QS Investors. "But what typically worked over the last 10 years is not all that likely to work well over the next 10 years. There is risk in markets, and investors will experience drawdowns, of varying magnitudes, in any given period."

"We've been perhaps seduced by this abnormally low volatility regime over the last several years, so we have opposing forces at play with our investor's portfolios: we need to fund their retirement, and we have to drive growth. Folks are worried about their equity allocations and the drawdowns they are likely to experience in their portfolios. What drives those drawdowns? They will happen. At some point we will have a recession again, not that we're calling for one."

Market-cap weighted indexes can fuel drawdowns, along with more cyclical sectors that tend to fuel underperformance in the market. The biggest sectors often have the biggest drawdowns.

"When we buy equities as an asset class, we really get two things," Mr. Petryk said. "One is the growth fueled by economic expansion, which has been more muted in recent years; but we also get the risk associated with that growth that comes with greater cyclicality. How can we get as much growth as possible with perhaps less risk in a portfolio? An important consideration when we think about total return is what you get from dividends versus capital appreciation."

"What fuels capital appreciation, and what might we expect from it as a component of return for equities? It is ultimately earnings growth, and valuation expansion. Where they are, valuation expansion is pretty unlikely, since valuations tend to mean-revert over the very long term. And the growth environment is likely to be relatively muted. With seeing lower returns due to capital appreciation, it is unlikely that it will be the key driver of returns over the next 10 years."

This makes dividends and income the key drivers and sources of return for equity allocations.

"We have been doing something across the vast majority of our institutional asset allocation books: defensive equity income," Mr. Petryk said. "The risk and return attributes are like a different asset class. Defensive equity income strategies tend to have less cyclicality. They are designed to seek less downside than traditional cap weighted approaches, and higher income. They still enable investors to target the growth they need and address funding requirements."

"We can use defensive equities as risk management tools whilst preserving our return expectations. They can be very powerful and useful from an outcome-oriented point of view. These strategies can offer value-oriented attributes, but they deliver superior Sharpe ratios³."

About Legg Mason 
Guided by a mission of Investing to Improve Lives,™ Legg Mason helps investors globally achieve better financial outcomes by expanding choice across investment strategies, vehicles and investor access through independent investment managers with diverse expertise in equity, fixed income, alternative and liquidity investments.  Legg Mason's assets under management are $767 billion as of February 28, 2018.  To learn more, visit our web site, our newsroom, or follow us on LinkedIn, Twitter, or Facebook. 

©2018 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc.

All investing involves risk. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.

¹ The Federal Reserve System is the central bank of the United States. It's composed of three key entities, including a Board of Governors, 12 Federal Reserve Banks and the Federal Open Market Committee. Investopedia
² The gross domestic product (GDP) is one of the primary indicators used to gauge the health of a country's economy. It represents the total dollar value of all goods and services produced over a specific time period, often referred to as the size of the economy. Investopedia.
³ The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Investopedia.

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