Reduce Risk – Mid-Year Market Outlook

As we approach the mid-year point in 2014, valuation concerns from two of the finest market observers have gone largely ignored. Indeed, economist Robert Shiller of Yale University and institutional money manager, Jeremy Grantham of GMO Inc. (two professionals with near-perfect track records calling market tops in both real estate and stocks), have expressed concerns with how far and fast asset class prices have run up from the trough in 2009. Yet, both stock and real estate prices are still climbing higher, with little apparent concern from an investing public that continues to chase both asset classes.

The VIX (a measure of fear and investor concern) is trading at near all-time lows, which shows how much complacency there is by stock investors who find no need to hedge their holdings with options and apparently aren’t concerned despite stocks trading at near record high valuations (CAPE – Cyclically Adjusted Price-Earnings ratio is over 25). Current high valuation levels are rarely reached, and, if history is a guide, the market will show negative or below-average returns in subsequent years.

Still, so far this year the Dow Jones Industrial Average has gained about one percentage point, and the broader S&P 500 is up about 4 percent while small-cap stocks have lagged. Europe has been relatively firm, with a gain of a few percent, but Japan remains the weakest link with a loss of nearly 10 percent. After lagging in 2013, real estate investment trusts have been tremendous performers so far in 2014, gaining nearly 15 percent.

At this point in the investing cycle and given lofty valuations confirmed by nearly every traditional measure, my suggestion is simple – reduce your risk. How? Sell some stock or mutual fund holdings that have moved well beyond normal valuation levels and protect your gains and your principal too. If you have 70 or 80 percent of your portfolio in stock holdings, you can easily reduce your risk by bringing the allocation down to 50 percent or less and moving the proceeds into cash or bonds (bonds are overvalued too, by the way, but not nearly as much as stocks, in my opinion). Having said that, it is nearly impossible to call short-term moves in the market and the stock-market party, which has been mostly enjoyed by the wealthy in our country and abroad, may well endure for another year or two.

Despite the potential for further gains, if you are concerned about protecting your portfolio and your profits, but you don’t want to engage in market timing by selling a portion of your stocks and moving the proceeds to cash or bonds, there is another option you might consider. One strategy that I employ for clients, that has gained popularity in recent years, is to reduce beta in a stock portfolio when valuations become stretched. Beta is measure of volatility of a security/stock relative to the market itself. If the stock market has a beta reading of 1, any holding with a beta of less than 1, should be less volatile and decline less than the market itself in a correction or bear market. For example, a stock with a beta reading of .50 would be expected to lose half as much as the S&P 500 during a market decline. So, holding a portfolio of low-beta stocks, during times when market valuations are well above average, makes complete sense for any rational investor. And, in my experience, most retirees and conservative investors much prefer to own stock or stock mutual funds that show less volatility than the market itself (low beta) in any market environment (bull or bear), regardless of valuation readings.

The table shown lists ten stocks with relatively low-beta readings, high safety and financial strength marks by Value Line, and annual dividend yields above current bond yields.

Bottom line, if you simply reduce the beta in your stock portfolio, and the market enters a difficult period of losses (eventually it will happen!) you will more than likely lose less money than you would have if you had done nothing. And, if the market continues higher, you will still participate, but with a low-beta portfolio you would expect to make less than the market itself if the bull-market rally continues. In my humble opinion, it’s a no-brainer to reduce risk at this time and either sell some of your stock holdings outright, or, at least reduce the beta of your portfolio. You should sleep better and probably lose considerably less money than if you had done nothing and we experience a correction or bear market.

Source: Value Line Stock Screener

At the time of publication, Stuart Chaussee and/or his clients held positions in AT&T, Coca-Cola, Consolidated Edison, Johnson & Johnson, PepsiCo., Procter & Gamble, Verizon and Southern Co. Holdings can change at any time. Under no circumstances does the information in this column represent investment advice or a recommendation to buy or sell securities.