The major stock indices soared to new all-time highs in recent weeks, driven by euphoria, hope and positive expectations for the future. Lurking in the dark corners behind these stock market gains are concerns that valuations are high, the bull cycle is getting old and potential triggers exist that could send stocks tumbling lower.
Investors can play defense and position their portfolio with some protection. Why should they worry?
The Standard & Poor’s 500 index has risen eight consecutive years, which is only the third time that’s happened since 1900, says Henry To, chief investment officer at CB Capital Partners in Dallas. “U.S. stocks are overvalued on almost every measure that I use,” he says.
[See: These IPOs May Be Huge Hits in 2017.]
The traditional price-earnings ratio for the S&P 500 is now near the highs seen during the technology bubble in 1999 and 2000, To says.
The forward 12-month P/E ratio on the S&P 500 stands at nearly 19:1, says David Schiegoleit, senior vice president and managing director of investments at U.S. Bank Wealth Management Private Client Reserve at U.S. Bank in Los Angeles.
“We view this as elevated, and not sustainable in the long run,” Schiegoleit says. “This most recent run-up is a repricing of risk given the changing administration, and the accompanying congressional balance of power. In the short term, this post-election rally is getting long in the tooth.”
Also, there’s always the threat of completely unexpected shocks lurking over the horizon, says Hilary Kramer, New York-based editor of the GameChangers stock newsletter. “A war, a disease outbreak, bank failure, trouble in Europe or a tense transition in Washington could all happen despite everyone’s best precautions, and if it does, markets are going to shake,” she says.
Analysts outline risks that could trigger a pullback or correction in the stock market.
“The most concerning factor here is the potential repealing of the individual mandate to purchase health care insurance under Obamacare,” To says.
“The individual mandate alone is keeping the system intact as it forces young and healthy Americans to purchase insurance to subsidize those with pre-existing conditions,” he says. “If Republicans repeal the individual mandate without an offsetting tax to keep the system afloat, U.S. health care insurance companies — and since they would still be forced to cover those with pre-existing conditions — may go bankrupt by the end of this decade.”
A potential spike in inflation is another threat, To says, as “wages are now rising at the quickest level in a decade.”
Also, the market has priced in a lot of positive changes coming from Washington, Schiegoleit says. These include decreases in corporate and personal income taxes, reduced regulatory constraints and increased infrastructure spending.
“If the eventual realities of any of these items the market is counting on turns out to be significantly different than expectation, we could see markets give back much of the Trump gains,” Schiegoleit says
Every investor needs a strong defense on the bench to cover when the market offense crumples, Kramer says.
“It’s always good to hedge your bets,” she says. “For my subscribers, the key is remaining agile and alert enough to dodge the shocks. And, of course it’s great to have positions you can cash in to rotate into short-term opportunities that emerge.”
[See: 9 Psychological Biases That Hurt Investors.]
Here are five ways you can protect your portfolio:
Buy volatility protection. “Right now volatility is extremely cheap, easily 18 to 20 percent below what we consider the low end of normal. A fund like ProShares Ultra VIX Short-Term Futures (ticker: UVXY) may not be a great idea as a permanent part of your portfolio, but when you think the bulls only have weeks or at most a month left to run, it’s worth betting on a volatility spike,” Kramer says.
Hedge with precious metals. If a stock market correction or a bear cycle emerges in 2017, it is likely to be triggered by higher-than-expected inflation and/or a significant economic slowdown, To says.
“Historically, gold has outperformed during times of higher-than-expected inflation and periods of economic uncertainty,” he says. “Investors can obtain exposure to gold by either buying the (SPDR Gold Shares) exchange-traded fund ( GLD), or gold coins such as American gold eagles.”
Kramer agrees. “If you’re really nervous, a sliver of your portfolio in a gold-mining stock like Barrick Gold Corp. ( ABX) or even a pure precious metals play like Central Fund of Canada is a fine way to preserve a little wealth through a stormy season. Even 5 to 10 percent is enough to ride through a short turn in the weather, and if things get worse for longer, the cushion should give you freedom to move,” she says.
Overweight defensive stocks. U.S. cyclical stocks, or stocks of companies sensitive to changes in economic conditions, outperformed U.S. defensive stocks by 18 percent during the second half of 2016, To says.
If the economic outlook slows down this quarter, he says U.S. defensive stocks will outperform both cyclical stocks and the S&P 500.
“In this scenario, you would want to buy stocks in the food retailing, real estate, professional services, and telecom industries, while underweighting or selling stocks in the banking, insurance, media, transportation and energy industries,” To says.
Keep your money rotating. Set sell targets for your strongest holdings, Kramer says. “When they start to look like they’ve topped out, go ahead and take your profit off the table. Most investors have been trained to hunt bargains after a market storm, but relatively few people remember to harvest winners when everything looks great. Be merciless,” Kramer says.
Consider hedge funds. Hedge funds are no longer solely for the high net-worth individuals. “There are hedge funds that utilize a mutual fund format, allowing access to almost any investor” that cover bonds, real estate and commodities,” Schiegoleit says.
“The purpose is to provide non-systemic, non-correlated, insulated returns to compliment the returns offered by any asset class,” he says.
[See: 7 of the Best ETFs to Own in 2017]
Investors can consult with a financial advisor to learn more about the risks, costs, and potential benefits of this strategy. Or, many online brokerage platforms offer robust screening services to help investors select funds, Schiegoleit says.
More from U.S. News
16 Things Investors Should Know About Crowdfunding
9 Ways to Invest in a Post-Election Market
20 Awesome Dividend Stocks for Guaranteed Income
5 Ways to Play Defense in an Aging Bull Market originally appeared on usnews.com
