This Bull Market Is Dead -- What to Do Now

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:

  1. 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.
  1. 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  ) .
  1. 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.
  1. 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.

Fool contributor Alex Dumortier loves macro-themed investing. Alex has no beneficial interest in any of the shares mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (12)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2010, at 4:52 PM, 2MoutAL wrote:

    I don't understand, in Reason 2 you mention the riskiness of Euro zone stocks but in your first recommmendation you say overweight in International. This sounds contradictory. Please clarify. Thanks.

  • Report this Comment On May 17, 2010, at 7:34 PM, ChrisBern wrote:

    2MoutAL - the same thought popped in my head. I suspect the author would favor International ex-Europe, e.g. economies such as Australia and emerging markets. But I'll let him speak for himself. :) Excellent article!

  • Report this Comment On May 17, 2010, at 11:39 PM, TMFAleph1 wrote:

    2MoutAL,

    On re-reading the article, I realize I was not particularly clear on this point.

    In fact, I think investors should be underweight both U.S. and international (including emerging market) equities. What I tried to express -- poorly -- is that the underweighting in U.S. stocks should be relatively larger than that for international/ emerging market stocks.

    At the asset class level, neither bonds nor stocks look particularly attractive right now (of course, one may be skillful at individual security selection, but that is a different game altogether). The true overweightings should be reserved for gold, cash, real assets such as timber, etc.

    I hope this helps clear things up.

    Best,

    Alex D

  • Report this Comment On May 18, 2010, at 11:40 AM, TMFAleph1 wrote:

    2MoutAL,

    The article text has been corrected so that there is no longer any possibility for confusion.

    Best,

    Alex D

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1184648, ~/Articles/ArticleHandler.aspx, 10/22/2014 11:47:38 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement