Bad News for the Rally

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The stock market is up more than 60% from its lows this past March, and investors have reacted with one overriding emotion -- fear. While folks are grateful to have earned back some of their losses, they are more afraid that the rally has run its course and is due for a breather, or even worse, another correction. And investors are putting their money where their fears are.

Preparing for the worst
One of the greatest beneficiaries of this new fearful mind-set has been bond funds. Fixed income funds have seen record inflows this year as battle-scarred investors seek out relative safety. But investors aren't totally ignoring equity funds. In fact, they've been making a pretty big bet on the stock market. More precisely, they're betting it'll fall.

Bear market funds and long-short funds have pulled in a record $10 billion so far this year, according to Morningstar data. That's more than twice the previous high of inflows in 2006. JPMorgan Chase (NYSE: JPM) and Pimco are reporting that they have been inundated with money flowing into these hedge fund-like offerings. And managers see more opportunity ahead in betting against the market -- 19 new long-short funds have opened this year alone.

One of the best-selling such funds has been Hussman Strategic Growth (HSGFX), which only lost 9% last year. In addition to being overweighted in consumer-services stocks such as retailer Aeropostale (NYSE: ARO), Amazon.com (Nasdaq: AMZN), and Panera Bread (Nasdaq: PNRA), the fund also has the ability to short the market, which is why its losses were so limited in 2008. So far this year, Strategic Growth has attracted roughly $1.7 billion in new money through September. Apparently, pessimism is the new optimism in the stock market.

Hindsight is 20/20
But before you give in to the mass panic and stuff all your money into a bear market fund, stop and take a deep breath. There are a few things to consider.

First of all: Has this rally come too far, too fast? It's completely possible. After all, beaten-down financials such as Bank of America (NYSE: BAC) and Wells Fargo (NYSE: WFC) have risen fivefold and fourfold, respectively, from their March lows. Even though long-term investors have still lost money on those stocks, that's a pretty hefty jump up. Yet it hardly feels like things are getting better on the economic front, so betting against the market seems like the way to go.

Keep in mind, though, that the stock market typically looks about six months or so down the road. It's probably already taken the risk of further economic difficulties into account. Just as the market headed down in 2007 well before the full extent of the economy's problems became evident, so too has the market headed up well in advance of a concrete economic recovery.

Chasing performance -- badly
Secondly, you need to realize that many investors are simply playing Monday morning quarterback with respect to the last bear market. Nothing makes a mutual fund or an asset class as attractive as hot recent returns. In this case, investors are looking at which corners of the market held up best in the horrible economic conditions of the past few years and are assuming that they are going to do just as well in the near future.

But investors are notorious for chasing returns and piling into sectors of the market at the exact wrong time. Just look at the tech run-up of the late 1990s for an example. After reaching its peak amid much fanfare and investor attention in late 1999, Microsoft (Nasdaq: MSFT) proceeded to lose well over half its value in 2000. A good rule of thumb is that if investors are moving en masse to a certain investment, it has probably already run its course and you're just late to the party.

Remember that most folks are terrible market timers. It's incredibly difficult to time the market with any degree of accuracy, even for smarty-pants money managers with lots of smarty-pants analysts working for them. I wouldn't rule out the possibility of a market correction in the near future -- but realize that you're probably not going to avoid all of the dip if it occurs, nor are you going to be able to catch all of the ensuing rebound if you are moving in and out of the market. Sometimes the only way to win is not to play the market-timing game.

Small steps win the race
If you're still losing sleep over another potential market correction, feel free to adjust your asset allocation to make it a bit more conservative -- but only if you're willing to miss out on further market appreciation. You could bump up your fixed income allocation, but realize that while bonds may protect your capital, they're not going to provide your portfolio with meaningful long-term growth.

Likewise, if you really want to hedge against a further market drop, you can buy a bear market or long-short mutual fund as long as you keep it to a very small percentage of your overall portfolio. Just realize that these types of funds lose money more often than they make it, so you might be taking on more risk than you realize!

We're living in uncertain times, and while many smart people have opinions on what is going to happen next, no one knows for sure. It's not easy to ignore the crowds and stay focused on your long-term goals in environments like this, but in the end, that path is much more likely to get you where you need to go.