Ratchet Down Your Market Expectations Now

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Includes: CVX, DIA, IWM, QQQ, RDS.B, SPY, XOM
by: Reuben Gregg Brewer

Summary

The bulls will tell you that the stock market can keep going higher.

The bears will tell you there's a market crash hiding in the wings.

The realist should be ready for middling returns either way.

Image Source: ExxonMobil Click to enlarge

The stock market has taken a couple of quick dips over the past year or so. But each time it's quickly recovered and still sits near recent highs. The bulls and the bears will tell you different stories about where we are today and what the potential is for tomorrow. But if you want to be realistic, you should be ready for middling results.

A slippery slope
In a recent Bloomberg article, David Hunt, who oversees about $1 trillion at Prudential Financial (NYSE:PRU), warned that investors shouldn't be expecting too much from the market today. He explained that, "The fact that people are unrealistic is actually creating risky behavior in the way that they are putting money to work." His concern is that too many people are trying to find 10% or higher returns in a world where a 10% return means taking on a lot of risk. He thinks something around 6% is more realistic.

John Bogle of Vanguard fame has also been talking up the need for investors to tone down their expectations. Only he's even more pessimistic. Late last year he told Morningstar that he expects stocks to return around 4% annually over the next decade. Just a couple of years earlier he was calling for 7%.

Then there's John Hussman, who runs the Hussman funds. He thinks the market will average around 2% annually over the next 12 years, but only because of dividends. Take out the dividends and stocks are flat, at best. Worse, he thinks the valuation of the current market hints that there's a notable risk of a crash that could wipe out around half the market's value. Of course if that happens, his expectations for the market will suddenly get a lot rosier!

Bull, bear, who cares
At the end of the day, you may or may not agree with these dour views. But you shouldn't ignore them. Yes, the market has a history of returning around 10% annually, but not every year and not over every stretch of time.

A brief look at the market's recent history should be enough to worry you. After the 2000 market peak the S&P 500 basically went nowhere for a decade or so. That said, there were distinct bull and bear markets within that span. It's just that the end result was sideways. With the market again sitting at high levels, you should probably rethink your expectations of 10% annualized returns year in and year out.

Of course the bulls can trot out evidence that there's more upside to come. Just like bears can explain why lower is more likely. In the end you and I are left to choose sides. Mr. Market is a fickle fellow and, with the market at lofty levels again, trimming your expectations is looking increasingly prudent. And so is preparing yourself for the worst case scenario.

I'm not suggesting that you run for the hills if you are inclined to be bullish. But it's probably worth the effort, just in case, to examining your portfolio and make sure you know what you own. Double check that you are still comfortable with the risk/reward profile of each company. Consider selling those that you aren't comfortable with, or at least start to watch them a bit closer. If the market starts to crack, you'll be glad you took the time to reassess your holdings before panic set in. If it doesn't crack, no harm no foul.

If you are a bit more bearish, meanwhile, you might want to actively cull out risky stocks. But, more important, you should look at making a wish list of companies that you'd really like to own if only they were cheaper. Doing that now will prepare you to buy when everyone else is selling scared.

And you might also want to look closely at the dividend payers in your portfolio. The income you receive from these stocks could help you live through a market decline, knowing that you are getting paid to wait for better days. All dividend payers aren't created equal, however. So make sure you are comfortable with the dividend stocks you've chosen to invest in.

CVX Chart

CVX data by YCharts

A comparison point or two
For example, Exxon Mobil (NYSE:XOM) just upped its dividend again but Chevron (NYSE:CVX) held pat. That's not to suggest that one company is better than the other, but their decisions say a lot about what their management and boards are thinking about the future. Then there are higher yielding competitors, like Shell (NYSE:RDS.B), which is in the midst of a big acquisition during an industry downturn. The nearly 7.5% yield puts Exxon's 3.3% yield to shame, but there's a reason for that. Shell has a long and storied history and I don't think its bad company. But that doesn't mean its dividend will hold up to low oil prices, particularly if the market around it falls out of bed.

If you are counting on that dividend to last through a bear market, you might find the risk you take on in Shell doesn't pan out as well as hoped. And you'll probably find that out at the worst possible time. If you want to be a Shell shareholder, that's fine, at least go in knowing that there's risk there.

During the market decline late last year and the one early in this year I found some stocks I thought offered a decent risk reward profile. Solid dividends in the 4% range and long histories of annual dividend hikes, meanwhile, should help me stay aboard the handful of companies I bought for a long time. And, I hope, I'll have the fortitude to buy more if the market does crater. Right now, however, I can't seem to find anything that interests me (Even the stocks I only just recently bought have sped higher). And when that happens, I know its time to step back, review what I own, and prepare myself... just in case.

In fact, the best thing that could happen is I'm wrong in my concerns! But with so many prominent investors saying its time to pull back expectations, I want to make sure I'm ready to be right.

Disclosure: I am/we are long XOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.