How to Dance with an Aging Bull

03/08/2013 8:30 am EST

Focus: STRATEGIES

James Stack

President, Stack Financial Management

The most profitable sectors and plays change as bull markets mature, so here's Jim Stack to explain how investors should adapt to today's market.

I am talking about strategy today with Jim Stack. Hi Jim, thanks for coming by.

Hi, Nancy.

Now, you have a safety-first strategy, which...today in the market, some people are saying it is overvalued, gone up so fast. So now people are starting to think about—OK—risky assets. Is it too risky? Should we start pulling some money out? So what do you think?

Well, stocks certainly aren’t as cheap as they were three to four years ago at the start of this bull market. That means you need to follow a different investment strategy than you did in the first two years.

We have to keep in mind that on a valuation basis, P/E ratio, the market is fairly valued today. We’re not overvalued, but we’re also not deeply undervalued, except with respect to interest rates and what you are getting from your money market fund.

But if you build a safety-first portfolio, what you really have to do is start from the top and build down. What is your overall allocation to the market? Right now, we feel that blocks are in place for the bull market. We are between 85% and 90% invested.

Secondly, you look at which sectors to invest in. And when you look at sectors today, you don’t want to be jumping into the highest-risk sectors. Those would include consumer discretionary—those are the strongest performers early in a bull market. They become higher risk at this stage.

So I would be cutting back on your consumer discretionary stocks. Cut back a little bit on financials if you are overweighted. Technology is also one of those higher-risk sectors, but technology is also one of the most undervalued sectors today, so we still like technology.

Now if we look ahead over the next several years, which sectors would do well if interest rates and inflation start to rise? We just completed a 60-year study, and here are the three top sectors if inflation and interest rates start to rise. They are energy, industrials, and materials. Those are the three sectors where you want to start increasing your allocation today.

Those have all done fairly well, too, but not as much as the others.

They haven’t...but again, we’re looking at bulletproofing the portfolio going forward, not trying to reach for those maximum gains and taking the undue risk in doing that.

The other way that you manage risk—the third way other than allocation and sector selection—is your stock picking. For stock picking, you want to focus on fundamentals and valuation.

There are a lot of great blue-chip companies out there, paying good dividends, selling at single-digit or low double-digit P/E ratios. That is where you want to be looking. Forget about the high flyers.

But they’re exciting.

Oh, they’re exciting! They’re an exciting ride up and a gut-wrenching ride down. But right now, you can go out and buy Chevron (CVX) with over a 3% dividend yield and a P/E ratio of nine.

Coca-Cola (KO) is fairly valued, but it is still a solid company. What Coke offers you is defensive hedge and protection against the dollar. If the dollar falls, 80% of Coke’s earnings are international. If the dollar falls 10%, its earnings go up 8%.

So you’re looking sort of the conservative way, also paying dividends. And don’t forget about international...at least multinationals with international…

I think you need to also look at the international, but look at it diversified. And I should mention the stocks I just mentioned we do hold in our managed accounts. It is important for disclosure.

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