Given the momentum the market has built up over the past few months, stocks will likely continue to advance a while longer—at least until we move into the seasonally weak May to October period. As prices rise, however, so do the odds of a sharp, sudden reversal.
Here are three potential pitfalls today’s ebullient investors are forgetting:
1) Monetary shenanigans. By forcing interest rates down (in some cases, to near zero) and purchasing trillions of dollars of dodgy debt, the Federal Reserve and other central banks have artificially inflated prices of a wide variety of assets, including stocks. Whenever this magical “stimulus” is withdrawn— even briefly, as in mid-2010 and mid-2011—the market recoils in terror, spooked by the prospect of an economic slowdown and lower company profits. It will happen again!
2) Demographic drain. Here’s a number that befuddles the mainstream media. Mutual funds that invest in U.S. stocks have suffered 10 straight months of net outflows, with $5.5 billion pouring out the door in January and February 2012 alone. In a rising market such as we’ve had year to date, investors usually buy stock funds. Why are they still dumping?
Because many of them have to. Roughly 10,000 Baby Boomers are turning 65 every day this year, and (as a group) they’re low on retirement savings. So they’re liquidating equity funds to pay living expenses—a trend that will persist, and accelerate, well into the middle of this decade. In other words, the Boomer undertow is putting a drag on the market even as Bernanke and other policymakers struggle to prop share prices up.
3) Europe, again. I wish I could say the Greek default was the end of the story. It almost certainly isn’t, though. Portuguese five-year government bonds now yield 16%, up from a mere 2.7% as recently December 2009. Such exorbitant borrowing costs imply that Spain’s next-door neighbor is fast running out of options, and that
Portugal will soon write a brand-new chapter of the European sovereign-debt crisis. France may not
be far behind if socialist wonk François Hollande, leading in the polls, wins the presidential election
run-off on May 6.
Looks like another fun-filled summer ahead!
How to Play Defense
With all these perils, and many others, strewn around, you might think I would be advising you to head for the hills. But I’m not. We’ve already taken significant defensive measures in our model portfolio by trimming our overall stock weighting to 51%. The other 49% consists of bonds, with an emphasis on short to intermediate maturities.
If you share my concerns about the risks in the current environment, the first thing you should do is make sure you’ve got enough assets allocated to fixed income. Bulk up on the low-risk Weitz Short-Intermediate Income Fund (MUTF:WSHNX). It hasn’t had a losing year since 1994. The fund’s shares are available through leading discount brokers, and carry an affordable $2,500 minimum. Current yield: 2%.
Once you’ve set your fixed-income stake, you can nibble selectively at our recommended stocks.
This month, I suggest focusing on companies that churn out huge amounts of free cash flow (excess cash
above what’s needed for operating purposes). If the market does run into trouble later this year, these
outfits have the financial muscle to buy back shares and cushion the blow.
Furthermore, businesses with ample cash hoards can take advantage of stock market declines by acquiring other businesses at bargain prices. Among my favorite cash gushers right now, two make their home in the healthcare space. Regardless of whether the 2010 healthcare act is retained or repealed, these players are poised to grow at a robust pace for years to come:
• AmerisourceBergen (NYSE:ABC). One of the nation’s largest drug wholesalers, ABC is a model of consistency. Earnings per share have soared almost 400% in the past 10 years, with gains in nine of the 10 annual frames. Along the way, the company has wisely used its burgeoning free cash flow for easily digestible tuck-in acquisitions and aggressive stock buybacks. Since 2006, ABC has shrunk its share count by a third—a “virtual dividend” of 7.6% a year. Combine that with the stock’s cash yield of 1.4%, and you’ve got a low-risk investment with a high probability of beating the market indexes over the long haul.
• Wellpoint (NYSE:WLP). This leading health insurer funnels its surplus cash right back into shareholder pockets. Over the past five years alone, WLP has retired a stupendous 45% of its outstanding stock. What’s more, the company expects to spend another $2.5 billion on buybacks in 2012.
As a result, each surviving share enjoys a rapidly increasing proportionate claim on Wellpoint’s profits. Assuming the buybacks continue at the same pace over the next five years as in the past five, earnings per share will grow 83% even if the firm’s total profits remain flat!