The S&P 500 may have risen more than 50% over the past 12 months, but new evidence suggests the rally might be cooling off. Time to panic? Not in the slightest.
The not-so-scary evidence
A Bloomberg article recently reported that stock mutual funds have spent their cash at the fastest clip in 18 years. That's left them with a relatively low cash reserve on average. If the funds don't have big piles of cash to keep buying up shares, it'll be hard for the market to keep advancing.
Cash reserves as a percentage of overall fund assets dropped from 5.7% early last year to 3.6% recently. True, that's a steep plunge -- but if a $1 billion fund had $57 million before, it would still have $36 million now. That's plenty of cash to buy any compelling investment that happens to catch its managers' eyes, and still have enough of a cushion left over to cover withdrawals. Mutual funds' total cash reserves recently rested at $172 billion, hardly a tiny sum. In short, funds will probably keep buying, though perhaps at slower pace.
More growth is possible
It's practically inevitable that the market will take a breather at some point. Investors can't reasonably expect consistent 50% returns in most 12-month periods, especially when the market has averaged 10% over the long haul.
But while it's fairly likely that the recent rally will slow down, the odds are also good that it will keep on going. Look at these annual returns for the S&P 500 over a recent 10-year span:
|
Year
|
S&P 500 Return
|
|
2000
|
(9%)
|
|
1999
|
21%
|
|
1998
|
29%
|
|
1997
|
34%
|
|
1996
|
23%
|
|
1995
|
38%
|
|
1994
|
1%
|
|
1993
|
10%
|
|
1992
|
8%
|
|
1991
|
31%
|
Data: Robert Shiller and Yahoo! Finance.
Only in 1993 did the return resemble the long-term average. One five-year stretch posted returns much higher than average. Who would have expected the market to rise in 1997, after it gained 38% in 1995 and 23% in 1996? But it kept right on climbing -- more than it should have, in all honesty -- in 1997, 1998, and 1999.
Your logical response
You could try to discern when the market has overheated, and switch to a defensive stance then (or shift a portion of your assets to cash). But in that case, you might miss out on more gains. If you've got a long investing horizon, just keep adding to the market regularly, no matter what it does.
And remember, even in overheated markets, you can always find bargains. During the dot-com crash, many old-school industries rocketed ahead. To give you some specific names, below I've provided four stocks that have solid growth rates, below-average valuations, and strong operational efficiency, as measured by return on equity. To top it off, each has a five-star rating (out of five) from our CAPS community of investors:
|
Company
|
Market Capitalization
|
3-Year Average Revenue Growth Rate
|
ROE
|
P/E
|
|
XTO Energy (NYSE: XTO )
|
$27 billion
|
27%
|
12%
|
14
|
|
Foster Wheeler (Nasdaq: FWLT )
|
$3 billion
|
15%
|
42%
|
10
|
|
Western Union (NYSE: WU )
|
$12 billion
|
5%
|
240%
|
14
|
|
PepsiCo (NYSE: PEP )
|
$102 billion
|
7%
|
36%
|
17
|
Two caveats: I don't present these four stocks as automatic buys, but as good places to look for quality companies in an overheated market. And don't read too much from any one number -- Western Union's steep return on equity (ROE) is partly due to considerable debt, which it's currently paying down.
In the end, don't spend too much time worrying about what will happen tomorrow, or even next month. To truly amass riches, you'll want to tune out the market's short-term noise, and focus on a much longer view.
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