As the domestic bull market rolls on, investors have enjoyed equity markets' nearly uninterrupted run-up over the past few years. Unfortunately, history tells us that the market can't grow forever -- contraction will inevitably follow expansion. Since the market's been growing for about four and a half years now, the odds favor a correction in our not-too-distant future. If a downturn is coming, how can investors avoid as much pain as possible?
A look at history
To see just how far we've come since the market bottom in 2002, look at the subsequent returns of some common equity indices:
|
Index |
Cumulative Return |
What a $10,000 Portfolio |
|---|---|---|
|
S&P 500 Index |
98% |
$19,755 |
|
Russell 2000 Index |
138% |
$23,757 |
|
Russell Mid-Cap Index |
156% |
$25,565 |
Now compare those returns with the prior four-and-a-half years of bull-market returns leading up to the market peak in 2000:
|
Index |
Cumulative Return |
What a $10,000 Portfolio |
|---|---|---|
|
S&P 500 Index |
177% |
$27,678 |
|
Russell 2000 Index |
84% |
$18,429 |
|
Russell Mid-Cap Index |
127% |
$22,707 |
Of course, we all know what happened after that:
|
Index |
Cumulative Return |
What a $10,000 Portfolio |
|---|---|---|
|
S&P 500 Index |
-44% |
$5,625 |
|
Russell 2000 Index |
-30% |
$6,952 |
|
Russell Mid-Cap Index |
-28% |
$7,207 |
Past performance trends don't guarantee future behavior. But these charts strongly suggest that after the run-up we've experienced, some sort of correction is likely in order.
Straight from the horse's mouth
A recent MarketWatch article revealed that several top value-fund managers, including those from Leuthold Weeden Capital Management, AIM Investments, Cambiar Investors, and Muhlenkamp & Co., all expected at least a minor pullback in the future. (None, however, expected anything as severe as the 2000-2002 bear market.)
In general, the managers interviewed hope to counteract that downturn by investing in companies with strong cash flows and above-average dividend yields. They're also avoiding cyclical industries, along with areas that have enjoyed the greatest recent gains.
Fools should also note that, while equity valuations marketwide are higher than they were two or three years ago, the overall market isn't tremendously overpriced. That seems to support predictions that any coming correction won't herald an extended bear market. Even a more limited downturn could still hurt your portfolio -- but a forewarned Fool is a forearmed Fool.
What to do
First, realize that investing is a long-term sport. These types of minor fluctuations happen, and the market will almost certainly rebound eventually. It hurts to see an unforgiving market erode your hard-earned portfolio, but these bumps generally even out over a long time horizon.
If you want to proactively adjust your portfolio, proceed with care. Never try to time the market; even investment professionals have trouble getting that strategy right. Instead, examine which sectors have done well during this bull-market run, and start to pare back those positions. Areas with the greatest gains become much more expensive than the rest of the market -- making them much more likely to falter when the going gets tough.
For example, while small-cap winners like Motley Fool Hidden Gems pick Volcom (NASDAQ:VLCM) or Cytyc (NASDAQ:CYTC) have given your portfolio a boost in the past, their current higher valuations suggest that you might want to consider reducing your small-cap exposure.
Likewise, large value stocks have been the hands-down favorite over their large growth counterparts for more than seven years now. Eventually, growth will gain the upper hand; make sure you get in on the ground floor. Stocking up on solid large growth stocks such as Celgene (NASDAQ:CELG) or Cognizant Technology Solutions (NASDAQ:CTSH) might be a smart move.
On the international front, while valuations in certain developed markets remain attractive, consider cutting back on emerging markets. These areas have been red hot the past few years, and they're starting to look somewhat speculative. If the U.S economy stumbles, emerging markets will be one of the first segments to follow.
It's impossible to know exactly when the next market correction is coming, or how bad it will be. We only know that it's coming, sooner or later. By shifting your portfolio into more attractively priced, less vulnerable areas of the market, you stand a much better chance of guarding your hard-won gains.
Further vigilant Foolishness:
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies mentioned herein. The Fool's disclosure policy always carries an umbrella, just in case.
