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Moves to Make… Before The Next Shoe Drops

Trying to process the news lately is downright exhausting. Wall Street is encouraged by President Trump’s pro-business policies, but fear is in the air. The daily barrage of sensational headlines prompts many investors to wonder: What’s the next shoe to drop?

Investors face a “good news-bad news” scenario.

The good news for the market is that earnings continue to come in strong.

For the just completed second-quarter, the latest consensus estimate for the S&P 500’s year-over-year earnings growth rate is 20%, according to research firm FactSet. If 20% is the actual growth rate for the quarter, it will mark the second highest earnings growth since the first quarter of 2011, when it came in at 19.5%.

At the sector level, analysts are most optimistic about technology (59%), followed by health care (59%) and energy (59%). The three sectors have the highest percentages of “buy” ratings.

The bad news is that valuations are at nosebleed levels. The cyclically adjusted price-earnings (CAPE) ratio, a valuation metric created by Nobel Laureate economist Robert Shiller, currently stands at 32.40. That level was exceeded only during the 1929 market peak, the 2000 dot-com frenzy, and the 2007 equities and sub-prime housing bubble.

Those historical precedents should scare even the toughest investor (see chart).

The worsening trade war only accentuates the risk of another big sell-off. In the tit-for-tat trade conflict, the sky has been filled on a daily basis with dropping shoes.

Other concerns should give you pause as well. Since 1961, recoveries on average have lasted about eight years — the current recovery started in June 2009. Do the math. According to time-proven cyclical patterns, an economic recession is in the cards for either 2018 of 2019.

Is the bull on its last legs?

The bull market is in its ninth year, which is perilously long by past standards. It’s now the second-longest bull run in history and it can’t defy gravity forever.

For the last four decades, every bull market has experienced a correction, which is simply a healthy restoration of equilibrium.

The steep market drops of February and March were brutal, but many money managers and financial opinion leaders are calling for further market swoons this year. By definition, a correction occurs when the market falls 10% from its 52-week high.

With stock valuations now at excessive levels, you should welcome a correction. It’s hard to find value nowadays; a correction would put many appealing but overpriced stocks back on the bargain shelf.

A correction is healthy; it acts as a cleansing mechanism that restores equilibrium. It separates the overpriced momentum stocks that you see hyped on CNBC from companies that are reasonably priced and can generate profits without assistance from artificial stimulation such as tax cuts and government policy.

While you’re bracing for the inevitable stock market declines, there’s one proactive move you can make now to protect your portfolio: Trim your growth stock allocation.

The crashes of 1929, 1981, 1987 and the more recent tumbles of 2007-2009 are all examples of situations when investing in only growth stocks with the highest potential return was not the wisest course of action.

Credible research studies have found that asset allocation explains nearly 100% of the level of investor returns. At the heart of asset allocation is the risk-return trade-off. Many investors make the mistake of setting their asset allocation once and then walking away. It’s not a one-time task; it’s a life-long process of fine-tuning.

The following allocations make sense now as a general rule (see pie chart).

As hedges, consider adding gold and silver to your portfolio. Precious metals are a classic safe haven, especially if inflation heats-up as most analysts expect. Commodities and agriculture-linked investments also help protect investors from the ravages of inflation.

Also consider using stop-losses. One of the most widely used devices for limiting the amount of loss from a dropping stock is to place a stop-loss order with your broker. Using this order, the trader will pre-set the value based on the maximum loss the investor is willing to tolerate.

If the price drops below this fixed value, the stop loss automatically becomes a market order and gets triggered. As soon as the price falls below the stop level, the position is closed at the current market price, which prevents any additional losses.

The “trailing stop loss” provides an advantage over a conventional stop loss because it’s more flexible. It allows the trader to continue protecting his capital if the price drops, but when the price increases, the trailing feature becomes active, enabling an eventual protection of profit while still reducing the risk to capital.

Over time, the trailing stop will self-calibrate, shifting from minimizing losses to protecting profits as the price reaches new highs.

Don’t wait to get hit on the head. Take these defensive measures now.

Got any questions or feedback? I’d love to hear from you: mailbag@investingdaily.com

John Persinos is managing editor at Investing Daily.

 

 


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