About a year ago, I wrote that it was time to lighten up on stocks.
Less than five months later, the Nasdaq Composite COMP, -0.72% had plunged 21%, the S&P 500 index SPX, -0.49% had slumped 17%, and the Dow Jones Industrial Average DJIA, -0.52% had fallen 14.5%.
Now the same conditions behind my cautious call last summer are shaping up again. We’re not yet at similar extremes. But we’re getting there.
This tells me it’s time to lighten up on stocks to prepare for the gathering storm. I’ve been telling subscribers of my stock newsletter Brush Up on Stocks to get out of dubious trades, get off margin, raise cash and be extra judicious about entering new positions.
I wouldn’t sell out of medium-term positions. But it does makes sense to tilt your portfolio to a more defensive posture. I’ll get into more detail on how to do that, including specific exchange-traded funds to own. But first, here’s what’s raising a cautionary flag on stocks in the system I used for making market calls in my stock letter.
Yellow flag rising
It’s all about sentiment. Investor are getting too bullish. That sounds like a good thing, right? After all, if investors are bullish that means the market will go up. Actually, though, it’s just the opposite. When investors are excessively bullish it means two things — both bad for stocks.
1. Investors are close to being fully invested. So they have less buying power on the sidelines to drive stocks higher.
2. Very bullish investors are overconfident and complacent. This makes them more prone to “surprise.” Since they don’t see much trouble ahead, they get surprised and frightened when anything bad does crop up. They’re more likely to get nervous and sell, since their entire bullish thesis gets easily knocked off track. Market weakness creates more angst, which sparks more selling.
What might get the ball rolling? I have no idea. But possible negatives include: Signs of rising inflation linked to tight labor markets; an inverted yield curve; negative geopolitical events linked to the new tensions in the Middle East; a breakdown in the endless China trade negotiations; a federal budget talk stand off; or some unknown unknown. I’m not predicting any of this will happen. The point is, if convincing negatives do crop up, over confident investor will be blindsided — and quick to sell.
It certainly isn’t reassuring that we’re entering the most vulnerable time of year for stocks — August through the end of October.
And I’m not the only one beginning to worry about rising investor sentiment. “Investors appear too complacent about market risks,” says Robert Doll, the chief equity strategist at Nuveen. He thinks investors are putting too much faith in possible bullish scenarios like a near-term resolution of the U.S.-China trade dispute or a boost to global growth from Chinese stimulus, not to mention the Fed’s ability to save the day. “We are currently cautious toward stocks,” concludes Doll.
Signs of overconfidence
I track about a dozen sentiment indicators for my stock letter. Right now they are all neutral at best, or bearish in the contrarian sense, meaning they show too much investor confidence. Here are four key examples.
1. The Chicago Board Options Exchange (CBOE) Volatility Index VIX, +9.69% is at 12. Below 16 is bearish, believes Baird chief investment strategist Bruce Bittles.
2. Investors Intelligence surveys show that 58% of investment advisers are bullish. Anything above 60% is bearish. We’re close.
3. A National Association of Active Investment Managers survey shows that 82% of them are bullish. This is high enough to be bearish.
4. The CBOE 3-Day Equity Put/Call Ratio is at 62%. Below 58% is bearish, so we are close.
The good news is that individual investors aren’t excessively bullish. The American Association of Individual Investors shows 36% are bullish and 29% are bearish. You have to have twice as many bulls as bears to get a bearish read here, says Bittles.
Another piece of good news is that President Donald Trump loves to highlight the stock market’s performance in stump speeches and during press gaggles on the way to his waiting helicopter. This tells us the “plunge protection team” (efforts by the government and the Fed to offset any sharp declines) will be out in full force now through the 2020 elections. So any sharp pullback could likely reverse.
What to do?
But insider sentiment is neutral, according to Vickers Stock Research, confirming this is a good time to be more cautious on long exposure. This, plus rising investor bullishness, suggest to me it’s time for the following five tactics.
1. Raise cash. Cash is the cleanest defense against downturns. Plus it will be nice to have buying power in a pullback. Meanwhile, you won’t miss out on much in the way of stock gains. Business profitability, measured by return on equity, is elevated. This likely caps additional earnings upside, says Doll. And stocks appear fully valued. The upshot for him: Limited upside for stocks and more volatility ahead.
2. Favor “high-quality” companies. Consider businesses that have good attributes like solid free cash flow and pricing power. Amazon.com AMZN, -0.67% Alphabet GOOG, -1.07% GOOGL, -0.99% and Facebook FB, -2.11% fit the bill. Here’s more on why these may be contrarian buys right now.
3. Buy gold. Gold GC00, -0.47% is the “go to” safe haven asset that typically does well when market turmoil increases. Sprott Asset Management portfolio manager Maria Smirnova thinks gold should also see continued strength because of global economic weakness, U.S.-China trade tensions, and growing geopolitical tensions in the Middle East. She also cites increased European Central Bank monetary easing, and a more dovish Fed.
For exposure to gold and silver, which can move up in line with gold, consider owning: SPDR Gold Shares GLD, -0.51% iShares Gold Trust IAU, -0.44% VanEck Vectors Gold Miners GDX, -2.26% Perth Mint Physical Gold ETF AAAU, -0.32% Aberdeen Standard Physical Swiss Gold Shares ETF SGOL, -0.53% Sprott Physical Gold and Silver Trust CEF, -0.65% and the Sprott Physical Silver Trust PSLV, -0.33%
4. Favor defensive areas. Two examples: Consumer staples and utilities. Consider owning the Vanguard Consumer Staples ETF VDC, -0.08% Consumer Staples Select Sector SPDR Fund XLP, -0.12% iShares Global Consumer Staples ETF KXI, -0.28% Vanguard Utilities ETF, Utilities Select Sector SPDR XLU, -0.62% and iShares U.S. Utilities ETF IDU, -0.55%
5. Stay in medium-term positions. It’s too hard to time market moves because you have to get two decisions right: the buy and the sell. This gets tough when emotions kick in. Since a recession is probably not just around the corner, it makes sense to stay in your core medium-term positions. “We don’t see the types of structural problems or excesses that would cause a recession over the next 12 months,” says Doll.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.