You hate to miss out when the market is rolling to new highs, but there's a creeping suspicion that this rally will top and crash as it did in 2000 or 2007. Here's how to keep the fear under control, writes MoneyShow's Jim Jubak, also of Jubak's Picks.
I think every market moment should have a theme song that sums up its emotional tone.
Right now, as US stocks sit at five-year or even all-time highs and the S&P 500 tries to decide if it really, really wants to break above 1,500 and stay there, I think we need a ditty that captures the worry that market good fortune can bring. One that reminds us that at points like this, the biggest danger to the rally is that investors will scare themselves into a market retreat.
If we can remind ourselves of that tendency, and make it conscious, then maybe we can do something about it—like try to figure out how much of the worry that we're feeling right now is a rational response to market conditions, and how much is emotional baggage that we should shrug off. We also need to figure out what kind of strategy we can use to cope with the possibility of a market retreat on sentiment.
That is the subject of this column. But let's begin with my choice for anthem for the moment: the Dan Hicks & The Hot Licks song "I Scare Myself."
The Wail of Worry
For those not familiar with the Dan Hicks oeuvre, "I Scare Myself" goes like this:
I scare myself
and I don't mean lightly
I scare myself
it can get frightenin'
I scare myself
to think what I could do
I scare myself
it's some kinda voodoo.
Why do those lyrics strike me as appropriate to the current market? Because they speak to the traditional investors' dilemma in a rising market.
We know we're supposed to let winners run (and cut our losses). But that advice is hard to follow, because we get nervous when the stocks we own rise. Our very good fortune makes us second-guess our good fortune. We can't help thinking that it's a good idea to get out before the market gods turn against us.
If it were just you and me having this random thought cross our minds, the best solution would be to find ourselves a good shrink. Maybe someone like Mel Brooks' Dr. Haldanish, who cured Bernice of her compulsion to tear paper by saying, "Bernice, don't tear paper." We'd do better as investors if we just got over our psychological problems.
But this isn't an individual psychological problem. It's a rising collective worry right now. And it's the collective nature of the worry that makes it a market force with the potential to move stocks. If you and I were the only investors or traders thinking about this, who'd care?
But you don't have to work to find evidence of the collective nature of this worry. In the past week or so, it has become a nagging voice that won't leave you alone.
There are the stories about market complacency and more reminders that stocks are at a five-year or record high. You don't have to dig very deep to hit subtext here: Remember, these stories urge, the tops and crashes of 2000 and 2007.
There are the survey stories that report individual investors are moving back into stocks. Or that this or that class of professional "smart-money" investors has become increasingly bullish.
The message here is pretty simple, if somewhat contradictory. Individual investors are "stupid money" that goes long stocks near a market top. Professional investors, on the other hand, aren't as smart as they think they are, and in their arrogance push strategies further than they were meant to go.
And finally there are the indicator stories—more or less based on more or less historical data—that discuss evidence that this market is nearing a top. An example is a piece by Mark Hulbert, the editor of Hulbert's Financial Digest, which cites a study by Ned Davis Research called "Leading Sectors for Calling Bull Market Peaks."
The financial and utility sectors, the study notes, have tended to underperform in the months leading up to bull-market peaks. The consumer discretionary and consumer staples, on the other hand, have tended to outperform.
And, unfortunately, Hulbert notes, returns in the past three months for three of these four sectors are consistent with the formation of a top. (The performance of the financial sector doesn't fit the pattern, but, Hulbert notes, maybe that's because the Federal Reserve's actions have propped up the sector. Perhaps, I'd say. But then the Federal Reserve's actions have propped up the whole market.)
The last time the market showed this four-sector pattern was in May 2011. That ushered in what turned out to be a 20% correction from the spring high by the time it ended in October.
On the Edge
It's easy to pooh-pooh these fears. After all, remember what has changed in the two weeks or so since we were cheering on the indexes as they recovered lost ground and appeared ready to make new highs.
The US debt ceiling battle is over for now. In Europe, Ireland and Portugal have moved closer to returning to the debt markets. The Bank of Japan is moving closer to a major new stimulus. And all the signs from China are pointing to slightly faster economic growth.
I don't much like the current stock market—to me, it is too dependent on a flood of cash from global central banks and not enough backed by fundamental growth. At some point, I worry, the central banks will have to take away the punch bowl and the party will end. The only question, in my opinion, is how fast the economy is growing by the time the stimulus comes to an end—and I fear it won't be growing very fast.
To me, these forces—central bank cash and slowing economic growth—are potential problems for the second half of the year. But right now, while I don't see any good fundamental reason for global stock markets to be rallying so strongly, I also don't see any event, forecast or report in the past week that says, "Hey, we've hit 1,500. Now it's time for a correction."
That doesn't mean, to my mind, however, that investors can simply ignore the possibility that we scare ourselves into a market retreat.
Biting the Apple
If you need evidence of why it's not good investing strategy to ignore a shift in market sentiment just because you think it is fundamentally wrong, take a look at what has happened to Apple (AAPL) shares over the past three months—and more specifically in the days since the company announced earnings for the first quarter of fiscal 2013.
I see no fundamental evidence that growth is over for Apple, that the company is about to suffer massive erosion of market share, that Apple can no longer innovate, or that margins are about to collapse. I simply don't see that story.
But that story has nonetheless driven the 38% drop in the stock from its high to the January 25 low. I see the carnage as a result of fear that there was no one left to buy Apple shares, a desire by analysts to avoid the blame that adhered to them in 2000 when Internet high flyers collapsed, and—mostly—a sense that Apple had to fall because it had climbed so high.
In other words, we scared ourselves.
But that doesn't mean Apple's loss is any less real—the dollars are still dollars. And it doesn't mean sentiment can simply be ignored. (Try telling your broker that the Apple shares you want to sell are actually worth $660 on the fundamentals, and that your brokerage statement should credit them to you at that price.)
Sentiment counts. Losses from sentiment count—even if you're convinced that the drop is just because our good fortune has scared us into selling.
So what do you do about the possibility that at 1,500 on the S&P 500 we're going to scare ourselves into a market retreat, simply because the market has climbed to 1,500?
Fighting the Fear
Start by covering the basics.
Make sure you know what you think the stuff you own is worth, based on the longer-term fundamentals. That will make it less likely that you'll get caught up in panic selling if sentiment moves against you. Part of this exercise is also to see if you've been caught up in sentiment on the upside and are holding stocks at prices you can't justify.
Do some risk-reward analysis. Markets (and individual stocks) do get overbought. That doesn't mean they're about to plunge. Most overbought markets don't plunge on the day they get overbought. Instead, they proceed to get more overbought.
But just because a market doesn't plunge when it becomes overbought doesn't mean the risk isn't rising. Fortunately, when an individual stock, sector, or country market is becoming overbought and more risky, there's usually something else out there that offers similar potential with less risk. And I find that taking some profits and reducing risk is easier to do (and frequently more profitable) if I've got an alternative destination for my money.
(In my experience, trying to sit out a rising market in cash is extremely difficult. One frequent pattern—and I've been here—is wisely moving to cash, but on the early side, then discovering that you can't stand sitting on the sidelines as the market rally continues. At some point—and frequently, this point is painfully close to the actual market turn—you can't take the pain anymore and jump back into the market just in time to catch the downturn.)
For example, if you think an individual stock or the entire housing sector in the United States is scarily high, think about taking profits in a homebuilder such as PulteGroup (PHM), up 178% in the past 12 months, and putting the money into Rayonier (RYN), up 22% with a 3.21% dividend yield.
There have been signs that some homebuilders are running into constraints on sales, created by low inventories of land. That might make a shift to a land-rich real-estate investment trust such as Rayonier a profitable and risk-reducing move.
If you think the entire US market is heading toward overbought, then maybe you look at individual stocks where future appreciation is likely to be driven by factors internal to the stocks.
Names that fit that description include MGM Resorts International (MGM), where the drivers are debt reduction and progress on the company's new casino on Macau's Cotai Strip, and Cheniere Energy (LNG), where the driver is progress on construction of the first liquid natural gas terminal approved to export natural gas from the United States.
Or if you find 1,500 on the S&P 500 scary-high, then maybe you take some profits on US stocks and put the money into Japanese and Chinese equities.
Japan's stock market is a relatively low-risk bet over the next month or two on a big asset-buying program from the Bank of Japan that will drive down the yen. Japanese exporters such as Toyota Motor (TM) or Ricoh (RICOY)—which is offered as 7752.JP in Tokyo—have huge leverage to a cheaper yen.
China's Hong Kong and Shanghai markets still have a long way to run before they start scaring investors with five-year or all-time highs. The Shanghai market, for example, was close to a four-year low as recently as December. At this early stage, financials and securities stocks such as Ping An Insurance (PNGAY) and Citic Securities (6030.HK in Hong Kong) come with more upside potential and less risk of a market top in sentiment.
I think any pullback in the US market caused by investors scaring themselves is likely to be relatively shallow and brief. I think there's significant money in cash or in bonds that would welcome a chance to buy into equities at a lower price.
But I'm fully aware that in saying that, I'm trying to judge sentiment among my fellow investors and to predict how investors will react to any market retreat. That's the shaky ground of supposition indeed.Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple, Cheniere Energy, MGM Resorts International, Ping An Insurance, and PulteGroup as of the end of September. For a full list of the stocks in the fund as of the end of September, see the fund’s portfolio here.