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3 Tips to Prepare for a Potential Stock Correction in 2014

Don't focus on trying to predict when we'll see a correction — just prepare for it

   

It’s getting a little too obvious to ignore. With the S&P 500 Index finishing up 30% in 2013 (and the small-cap Russell 2000 rocketing ahead 37%), more and more observers are admitting that U.S. stocks look rather bubbly in here. Even the perennially bullish Larry Fink, CEO of the world’s largest money manager, BlackRock (BLK), used the “B” word to an elite gathering in Chicago.

Is there any factual basis to the bubble talkers’ concerns?

Well, yes. Objective signs of an overvalued market have been with us for some time. On a number of occasions, I’ve called your attention to the cyclically adjusted price-to-earnings (CAPE) ratio, devised by Professor Robert Shiller of Yale. To smooth out the sharp earnings fluctuations that occur around recessions, the CAPE ratio takes 10 years of corporate profits and adjusts them for inflation.

ShillerPE 3 Tips to Prepare for a Potential Stock Correction in 2014

Source: Multpl.com

As you can see from the chart, the Shiller P/E near the end of 2013 stood at more than 26. Since 1881, this benchmark has averaged 16.5. Merely to return to fair value, the S&P 500 Index would have to drop approximately 36%, to around 1200. An undervalued reading, at 12, would take the S&P down to less than 900 (from current prices around 1837).

While I don’t expect to see either 900 or 1200 in the near future, the increasingly noisy “bubble babble” among institutional investors tells us something. Many influential members of the Big Money herd are already nervously pawing the ground and worrying about a stock correction.

Sooner or later, some incident — perhaps quite minor in itself — will arouse a critical mass of fear among the leading animals. A selling stampede will result.

Prepare, Don’t Predict

Unfortunately, it’s next to impossible to pinpoint beforehand when the mood of the crowd will reverse. Therefore, I advise you to concentrate your energies on preparing for a stock correction rather than predicting. Here are three tips to help you put your portfolio into shape before the bubble trouble boils over:

Establish a reasonable asset mix that will let you sleep well, come what may: In the current environment, I would recommend carrying a somewhat lower stock weighting than normal (for you). Adjust the equity stake up or down to match your own risk tolerance, and increase your exposure to fixed-income securities that will hold your portfolio steady in a storm.

Devote at least as much energy to your sell list as your buy list: Pare your holdings of stocks that have climbed to the top of their P/E range of the past five years. (You can find this information in the company’s S&P tearsheet, available through the online research sites of most stockbrokers.) Subscribers of Profitable Investing know that we’ve been taking profits on some of the high-flying names of the model portfolio recommendations. Depending on your tax situation, you may find it advisable to trim other holdings as well, with a goal of buying back in another two or three months. Besides high P/E names, you should exit — or at least reduce your exposure to — any stocks that fell by a larger percentage than the S&P 500 during the 2007-09 plunge. Make it a priority to dispose of these high-risk holdings before year’s end.

For new money, emphasize investments that throw off an ample cash yield: If the financial markets run into rough weather in 2014, you can be sure that “yield assets” will hold up far better than pure capital-gains plays. On the fixed-income side of the ledger, I favor emerging-markets bonds as well as domestic preferred stocks and bank-loan funds.

Richard Band is the editor of Profitable Investing.

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