Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
There is no question that riding the bull market that began in March 2009 has been profitable journey. Trough to peak -- from March 9, 2009 through April 23 of this year -- the S&P 500 produced a stunning 80% gain. However, it is well past time investors took some of those gains off the table, as it looks like this bull has stampeded past the doors of a slaughterhouse. Indeed, there are at least three reasons to believe the next phase will produce either a correction or a prolonged period of stagnant stock prices. Here's why and what investors should do about it.
Reason 1: The cyclical bull must bow to the secular bear
Although the stock market rally has been intense, it is no more than a cyclical bull market that occurred "with the permission" of its secular bear master. This is not uncommon: For example, although Japanese stocks gained 79% in 1998-2000, even at its peak in 2000, the Nikkei 225 was barely more than halfway to its 1990 all-time high. The secular trend ultimately dominates any cyclical upswings. Major financial crises produce secular bear markets that are multiyear phenomena; the excesses of the credit crisis cannot be wiped away in a single year.
Reason 2: A Sovereign debt crisis (or 'Risk premia up, economic growth down')
The impact of the Eurozone debt crisis is twofold: On the one hand, we should expect global growth to fail to achieve previous estimates, as Europe becomes an even greater laggard than it already was. (The euro area and the European Union barely grew at all in the first quarter, both registering GDP growth of just 0.2%.)
The other effect is the creeping realization that the world remains a risky place and the knock-on impact on the price investors are willing to pay to own "risky" assets. I say "creeping realization" because despite increased volatility, the market is still adjusting to the new reality of which the Eurozone debt crisis is but one manifestation, not an exceptional occurrence.
The signs that risk is garnering new respect – and becoming more expensive – are everywhere: The VIX index, known as Wall Street's "fear gauge" -- has shot up 88% since the market peaked on April 23. Last week, investors withdrew $1.7 billion from junk bond mutual funds, the third-largest withdrawal ever. Although the risk premium on stocks isn't directly observable, increased (downside) volatility suggests it is increasing. This process will continue as investors come to grips with the fact that transferring debt from corporate to government balance sheets doesn't make it disappear.
Reason 3: Stocks are demonstrably overvalued
By any useful measure, stocks are demonstrably overvalued. For example, the cyclically adjusted P/E (CAPE) multiple of the S&P 500 is 20.6 (the CAPE is calculated using a 10-year average of inflation-adjusted earnings). Professor Robert Shiller of Yale, who has compiled stock market data going back to 1871, has found that once the CAPE rises above 20, stocks have lost 2% a year after inflation during the following decade (accounting for dividends produces a small positive total real return).
4 recommendations for investors
In this context, I have four recommendations:
- If your U.S. equity exposure is through broad-market index products such as the SPDR S&P 500 (NYSE: SPY ) , you should now be underweight U.S. stocks.
- If you wish to maintain a full allocation to U.S. stocks, I suggest you favor high-quality, large-cap stocks over small-cap stocks. Prefer the SPDR S&P Dividend ETF (NYSE: SDY ) , or the Vanguard High Dividend Yield ETF (NYSE: VYM ) , for example, over the iShares Russell 2000 ETF (NYSE: IWM ) .
- If you invest in individual stocks, it may be acceptable to maintain a full allocation to U.S. stocks if you have some degree of confidence that the stocks you own still offer a margin of safety. At less than 9 times estimated 2011 earnings, both Merck (NYSE: MRK ) and ExxonMobil (NYSE: XOM ) look like they fit the bill as cheap, high-quality names.
- There is nothing wrong with holding cash at this time. At the asset class level, genuinely attractive opportunities are very limited right now. I expect that to change over the next few months as increased price volatility offers new investment opportunities.
Bet on the butcher, not the lamb (or the bull)
I could be wrong about this being the end of the bull market; for all I know, this bull could shake off these latest jitters like a straggler in Pamplona, with the S&P 500 shooting off once more to chase its all-time highs. However, to use another livestock analogy, when the lamb is facing the butcher's knife, it might rise up and kill the butcher, but I always prefer to bet on the butcher. In this case, betting on the butcher means betting against the bull.
The U.S. and Europe are stuck with an enormous government debt problem that is going to depress stock returns, but Tim Hanson knows how to make more in 2010.