Talk about surprises. Investors were convinced stock markets would zig this year. So naturally they zagged.

While investors braced for a seemingly inevitable U.S. recession and related market weakness, the S&P 500 Index made a surprising rebound, advancing 16.9% for the six months ended June 30, 2023. Europe and Japan, faced with their own economic challenges, have extended their strong runs as well, climbing 13.6% and 13.0% respectively, as measured by the MSCI Europe and MSCI Japan indexes.

“Markets have a history of surprising investors and showing resilience when circumstances appear bleak,” says Caroline Randall, a portfolio manager for Capital Income Builder®. “The lesson for investors who don’t want to miss these opportunities? Be brave and stay invested in companies that can weather a potential storm.”

Stranded on the sidelines

Indeed, the good news may be a mixed blessing for some. That’s because investors fled both stock and bond markets in 2022, shifting assets to cash and cash alternatives amid deteriorating economic conditions. Money market accounts held a record $5.43 trillion as of June 30, 2023. With stock prices higher than they were six months ago and a U.S. recession still in the cards, many may feel even more nervous about getting back in the market than they did in January.

“With all the uncertainty swirling around us — uncertainty about inflation, rates, war and recession — it is understandable that people feel uncomfortable,” Randall says. “But if you wait to invest until you have seen enough data to feel confident about investing, it's probably going to be too late because the rest of the market has that information. My message for investors is, get comfortable with the uncomfortable.”

Here are some reasons long-term investors may want to consider leaving the sidelines and using a more balanced investing approach that includes a mix of stocks and bonds as well as cash.

Record cash levels are a bullish sign

The record level of assets in cash and cash alternatives could represent a catalyst for further market gains. History shows that money market assets have peaked at or near past market bottoms. During the depths of the COVID pandemic in May 2020, money market fund totals peaked just weeks after the S&P 500 troughed in March.

Asset flows followed a similar pattern during the global financial crisis, when money market fund assets peaked two months before the S&P 500 bottomed on March 9, 2009. The stock market recorded a 40% return over the subsequent three months and a 55% return over the following six months.

As inflation peaks and the Federal Reserve eventually ends its rate tightening cycle, cash is likely going to be looking for a home, potentially driving returns for stocks and bonds. Now may be the right time for investors to work with their financial professionals and review overall asset allocations. For cautious investors who may invest their cash gradually over the next six months or more, the return potential may outweigh the risk of getting back into the market too early.

The narrow market rally may broaden

Thus far the U.S. stock market rally has been limited in scope. This year through June 5, 90% of returns for the S&P 500 have been concentrated among a small group of technology companies, such as Microsoft, NVIDIA, Meta and Alphabet. Investor enthusiasm for breakthroughs in artificial intelligence (AI) sent some share prices and valuations soaring. NVIDIA, largely known for its video game chips, eclipsed $1 trillion in market value after making bullish comments in May about potential revenue from demand for its processors used in AI computing.

Valuations among these stocks have soared. But other areas of the U.S. market and international markets may offer more compelling valuations. The price-to-earnings ratio for the S&P 500 technology sector was 27.4 times earnings as of June 30, compared with 19.5 times earnings for the broader S&P 500. In international markets, the valuation for the broader MSCI Europe Index, at 12.4 times earnings, was below its 10-year average of 14.2, even after recent strong returns.

“You have to pay close attention to individual markets and individual companies,” Randall says. “Because the market leadership has been incredibly narrow, I think that there are still some interesting investment opportunities across a range of sectors and geographies.”

Historically, narrow market rallies have often been followed by steady gains for the broader market. To be sure, investors must consider that should euphoria over AI subside, a pullback in tech stocks could stifle a broader rally. As of June, however, all 11 sectors in the S&P 500 generated positive results.

Tailwinds are emerging beyond U.S. tech

So where might cautious investors look for opportunity? For Greg Wendt, a portfolio manager for AMCAP Fund®, innovation is key to identifying investment opportunity, not only within the technology sector, but across the economy.

“Innovation has always been a pathway for growth and long-term success,” says Wendt, who has been following a wave of advances in the medical devices industry and among consumer companies.

Companies like Insulet and Dexcom are developing devices for diabetics that enable remote monitoring and delivery of insulin at critical moments using predictive algorithms. “Because so many surgical procedures were delayed during the pandemic, I also expect pent-up demand to drive growth for many of these medical device companies,” Wendt adds.

One of the most surprising developments in 2023 has been the strength of Japan’s stock market. A weaker dollar has been a tailwind for international investing broadly. In addition, corporate reforms have been initiated in Japan that are making companies more compelling for investors. Among these are actions to increase dividend payout ratios and share buybacks.

“The corporate mindset in Japan is shifting toward understanding the need to better reward shareholders, and as a result we're seeing some improving and different attitudes around raising dividend payout ratios for companies,” Randall says.

Some notable companies have also undergone transformations of their own to become more competitive globally. Within the traditional film and camera industry, for example, Olympus has transformed itself into the world’s leading supplier of endoscopes, medical instruments with image sensors used to explore internal organs, and Fujifilm has evolved into a participant in health care, offering drug development and manufacturing services to pharmaceutical companies.

In Europe, economic growth has been unexpectedly positive, and the continent has navigated its energy challenges and the war in Ukraine better than many anticipated. “Germany in particular survived what could have been a very tough winter, and a lot of German companies have global businesses,” Randall says. For example, if you look at a company like DHL Group, a logistics and mail services company with an e-commerce delivery service, it has extensive operations, including in the U.S. and China, Randall notes.

We may have reached maximum pessimism

Challenges, of course, remain. Although inflation is easing, it continues to be elevated. Central banks including the Fed have indicated that they are not finished raising interest rates. And a recession, albeit a shallow one, remains likely at some point.

“We've never seen a full employment recession before,” Wendt says. “That's why I think the recession could be a reasonably shallow one, and I don’t think we’ll be up late at night trying to figure out how we're going to get through it.”

So, have stocks entered a new bull market?

“I think it is fair to ask whether the October 2022 market lows were the lows for this cycle,” Wendt continues. “I believe that they are. That doesn’t mean we are off to the races, but we may have already been through the period of maximum pessimism. History has taught us that markets can do surprising things, often when conditions appear bleak.”