4 Tips to Guide You Before the Bubble Bursts

by Richard Band | November 20, 2013 5:35 pm

 “Blackrock’s Fink says there are bubble-like markets again.”(Bloomberg headline, October 29)

It’s getting a little too obvious to ignore. With the S&P 500 index up 26% year to date as we speak (and the small-cap Russell 2000 index rocketing ahead 31%), 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, used the b-word to an elite gathering in Chicago a few weeks ago.

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–Earnings (CAPE) ratio, devised by Prof. 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.

Today the Shiller P/E now stands at more than 24X. Since 1881, this benchmark has averaged 16.5X. Merely to return to fair value, the S&P 500 index would have to drop approximately 32%, to around 1200. An undervalued reading, at 12X, would take the S&P down to less than 900 (from a recent high of 1798).

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. 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 rather than predicting. Here are four tips to help you put your portfolio into shape before the bubble trouble boils over:

1) Establish a reasonable asset mix that will let you sleep well, come what may.

At present, a mix of 53% stocks, 47% fixed income seems right. You’re welcome to tinker with that figure, adjusting the equity stake up or down to match your own risk tolerance. In any event, though, you should be carrying a somewhat lower stock weighting than normal (for you).

2) 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.).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 2007–2009 plunge. Make it a priority to dispose of these high-risk holdings before year-end.

3) 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.

4) If you’re an active trader, consider hedging your bets.

Once the stock market’s year-end strength dissipates (probably sometime between mid-December and mid-January), I expect to recommend several hedges. The simplest and safest is to buy long-dated Treasury bonds as insurance against an equity selloff. During the Dow’s 2011 “correction,” for example,a typical long T-bond surged almost 35%, including reinvested interest.

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