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When Will It Be Time to Pull Back From These Markets?

05/24/2013

Maintaining a high exposure to the stock market has been a winning strategy since March 2009 when the market reached its low following the financial crisis. As a result, investors who opted for a high allocation to stock funds and stock ETFs have made out well. But how much longer is it wise for the average investor to assume allocations at high levels will continue to pay off?

Of course, a parallel question relates to the bond market. In this regard, a high allocation to bonds when considered on a 5 year or even longer-term basis, has proven to be a lower risk, and in some cases, a better performing strategy than investing in many categories of stock funds. And compared to merely investing in CDs or money market funds, bond funds would have proven an elixir, even for conservative investors. But is it now too late to expect further gains, and should bond fund investors instead seriously consider reducing their exposure?

This article will attempt to answer these questions, always bearing in mind that people (even experts) who try to divine these answers are often on the wrong track to begin with. Why? Because how the markets will perform, especially based on short-term considerations, are typically irrelevant for long-term investors and often take your eye off the bigger question: Will you be better off in a year or two (or even more so in 5 or more years) if you simply stick with a strategy of keeping most of your money invested in a diversified portfolio, typically consisting of mainly stocks, a modicum of bonds, and very little cash, than when you are prone to make wholesale moves altering this formula too much.

Stocks
During the last 50+ months post the March 9, 2009 low, stocks have gained about the same amount as during the huge tech bubble that ran from early 1996 to March 2000, that is, in excess of 25% annualized. Of course, that streak ended badly when the bubble subsequently popped. While the same may not happen this time since the current market doesn’t appear to be overvalued as the prior period proved to be, the outsized gains should be viewed in historical perspective to see just how far we have come.

Subsequent to its closing low, the return including dividends on the S&P 500 index over the period as of this writing has been a staggering 165%. It turns out that such a gain without the onset of a 20% drop signifying a bear market is among the biggest since 1929, surpassed only by the long-term performance of the late ’87 to 2000 market, as well as two periods in the 40′s and 50′s, and the 5 years that preceded the ’87 crash.

Each calendar quarter, my Newsletter issues a new set of allocations to stocks, bonds, and cash along with a Model Portfolio of recommended funds and ETFs. Ever since April 2009, my recommendations have been to continuously raise the allocation made to stocks or at least hold them steady.

While new allocations will not appear until next month, the question that should currently be on many investors minds is this: Given the huge gains described above, is it now the time to suggest that investors should seriously consider cutting back stock allocations that we have continued to recommend at these high levels?

My research suggests, in agreement with quite a few other sources, that most categories of stock funds are not currently near being overvalued, at least not yet. Further, the strong momentum apparently caused by investors now adding to their stock positions tends to create a virtuous cycle. But at a certain point, stocks will start to become overvalued and it may be crucial for investors to recognize when this overvaluation stage is reached.

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