Great Market Gains, But the Challenge Is to Keep Them

by Richard Band | November 8, 2012 7:02 am

Great Market Gains, But the Challenge Is to Keep Them

For investors who don’t mind taking risks, 2012 has proved to be a year of surprisingly broad rewards. Stocks have surged (most of all here in the United States), with the benchmark Standard & Poor’s 500 index up nearly 14% year to date.

Gold has jumped 12%. Treasury bonds have managed only a slim advance, but lower-grade (“junk”) paper has returned 12%, including both interest and price gains.

All quite wonderful. However, it’s worth asking how these marvelous profits came to be. Is it because the U.S. economy is booming? Hardly. The financial markets are flexing their 15-inch biceps because Dr. Bernanke has injected the system with steroids (near-free money).

When the treatments stop or even slow down, as they must eventually, the markets will face a painful “correction.” I estimate that the blue chip U.S. stock indexes, for example, could drop 20%-30% before reaching fair value on such metrics as the price-to-sales ratio or the replacement cost of corporate assets.

Corporate bonds, too, and precious metals will likely fall once the Federal Reserve’s stimulus efforts wind down. Gold could easily retreat to $1,200 an ounce or less, from its recent highs near $1,800.

Strategy for the Endgame

The problem for investors, of course, is that we don’t know when the big breakdown will occur. Risk assets could rally for another month, or another year, before running into serious headwinds. Rather than slap a precise date on something that can’t be known in advance, I recommend that you follow a disciplined four-part strategy as the markets work their way toward an ultimate cyclical peak:

1) Diversify among asset classes.

As tempting as it may be to load up on stocks after they’ve performed so well, I caution you that past returns are just that— past. History suggests that when the bubble bursts, the markets that soared the most will fall hardest. Maintain enough exposure to high-grade bonds (even Treasuries!) and cash to provide a cushion if your riskier assets suddenly hit the skids.

Stocks should represent no more than 51% of your total portfolio, and for or precious metals, I suggest a maximum of 10%.

2) Cull your portfolio periodically.

At any point in the market cycle, some stocks are rolling downhill while others are just beginning their ascent. To make room for tomorrow’s winners, I suggest culling stocks that have climbed at an unsustainable pace over the past 12 months (more than 40%, say).

In addition, with year-end approaching, you should plan to book some losses in your taxable accounts. As a rule of thumb, I would consider selling any stock held at a loss if the share price hasn’t made a new high for 2012 since last April.

3) Buy pullbacks only.

This principle applies to everything you buy, not just stocks. The lower the price you pay, the higher your future return. From May to July, during the last significant dip for precious metals, we scooped up silver and platinum via two exchange-traded bullion funds. Those funds have now bounced 28% and20%, respectively, off their spring/summer lows. Thus, I rate them a hold at current levels.

Likewise, I wouldn’t add to most stock-based mutual funds right now. On the other hand, if the
metals or the headline stock indexes were to pull back 6%–8% from their recent peaks, I would start accumulating again.

4) Focus on cash yield.

Late in a market uptrend, investors often assume that additional price gains are a slam dunk. Just the opposite is true, though. As you approach the top, any remaining capital appreciation for the current cycle shrinks to the vanishing point.

That’s why it makes sense, at this stage, to insist that your new investment purchases churn out a plump cash yield. With each income check you receive, you get back part of your original capital, lowering your threshold for earning a positive return on the asset.

Furthermore, if you reinvest your dividends and interest, you harness the awesome power of
compounding. Your wealth snowballs, because it’s growing from a larger and larger base. Or as Ben Franklin put it more elegantly, “Money makes money, and the money money makes, makes more money.”

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