Is the Rally Losing Steam?

Leo Kolivakis's picture

Via Pension Pulse.

Ben Levihsohn and Jane J. Kim of the WSJ wrote an interesting weekend piece, How to Play a Market Rally:

Forget "buy and hold." It is time to time the stock market.

 

For
10 long years, market rallies have ended badly for investors. Now,
with stocks up 15.6% in four months, strategists are beginning to
suggest that ordinary investors start dialing back on risk.

 

That
doesn't mean dumping shares willy-nilly. With the Federal Reserve
committed to flooding markets with liquidity, it still makes sense to
be in equities. But "if you've ridden the market up, you might want to
do some trimming," says Steven Shueh, managing partner at Roundview
Capital.

 

Some investors may already be starting. The Dow Jones Industrial Average has given up 2.2% from its Nov. 5 high.

 

The
first step is to disabuse yourself of the notion that it's impossible
to time the market. It turns out that sometimes you can. When markets
are stuck in a trading range for an extended period, selling into
strength and buying into weakness can outperform buy-and-hold
investing.

 

If that sounds like
sacrilege, it may be because mutual-fund firms have spent decades
persuading you to keep your money in their stock funds through thick
and thin so they could collect bigger profits.

 

Consider
an investor with a $1 million portfolio on Dec. 24, 1998, the first
time the Standard & Poor's 500-stock index was at its current
level. But if the investor had merely held on, he would have seen
essentially zero appreciation through Nov. 11 of this year. If that
same investor instead had sold one-tenth of his portfolio every time
the stock market gained 20% and allocated one-fifth of his cash to the
market when stocks fell more than 10%, he would have gained about
$140,000, according to a Wall Street Journal analysis.

 

An
approach using broad valuation measures performed even better. One
metric, the ratio of stock-market capitalization to gross domestic
product, tracks the market's value versus that of the underlying
economy. An investor with $1 million on Dec. 24, 1998, who sold 10% at
the end of each month when the ratio was above 115% and bought stocks
with 20% of his cash when the ratio was below 75%, produced a gain of
around $365,000. (The average has been about 91% over the past 20
years.)

 

Of course, investing success depends greatly on when you
start. If you had tried the strategy at the market low of October 2002,
for example, you would have come out about the same as if you had
bought and held.

 

Throughout this year the market has traded in a
band of about 20%—far away from both its 2007 high and its 2009 low.
Stocks gained 15% from Feb. 8 to April 23 on hopes that a robust
economic recovery in the U.S. would sustain global growth. By July 2,
it had dropped 16% to 1022.58, as disappointing economic data fueled
fears of a double-dip recession.

 

Now stocks are up again—but for how long?

 

Says Tobias Levkovich, head of U.S. equity strategy at Citigroup Inc.: "Investors should be more willing to hedge."

 

The
smartest way to do that now, strategists say, is to switch from
riskier holdings to steadier stocks and dividend payers; to embrace
"tactical" mutual funds that can jump in and out of asset classes; and
to consider bond funds designed to benefit from rising interest rates.

 

Dividends

 

Investors
looking for safer stock plays should consider companies that are
initiating or boosting dividends, say strategists. Such companies tend
to be less volatile than the overall stock market. According to Ned
Davis Research, their "beta," a measure of volatility, is just 0.78
versus the broad market, compared with 1.08 for non-dividend payers. (A
beta of 1.0 means a stock is as risky as the market.)

 

Dividend
payers may be especially attractive at this stage of the bull market.
Whereas non-dividend stocks typically trounce dividend payers during
the first leg of a bull run, dividend stocks since 1974 have
outperformed by three percentage points during the second leg and seven
percentage points during the third, according to Ned Davis Research.

 

"The
biggest headwind for dividend stocks occurs in the very early stages
of the bull market, and we're past that in all likelihood," says Ed
Clissold, global equity strategist at Ned Davis.

 

Some dividend boosters in the S&P 500 include Dr Pepper Snapple Group Inc., Time Warner Cable Inc., Starbucks Corp., International Paper Co. and UnitedHealth Group Inc.

 

Big Tech

 

The
four-month rally has been led by the technology sector: the Nasdaq's
20.4% rise has outpaced the Standard & Poor's 500-stock index's
17.3% jump. Yet the tech sector has a price-earnings ratio of 13.7,
only slightly higher than the 13.3 P/E for the market as a whole,
according to Thomson Reuters data. Tech also has the fourth-lowest P/E of the 10 major market sectors.

 

Investors
concerned that the rally is overstretched might want to shift away
from highfliers and toward the 10 largest tech stocks, which Bank of
America Merrill Lynch dubs the "tech titans"—Microsoft Corp., International Business Machines Corp., Apple Inc., Intel Corp., Hewlett-Packard Co., Cisco Systems Inc., Oracle Corp., Google Inc., Qualcomm Inc. and Corning Inc.

 

Cisco, in particular, may be a better deal now after Thursday's 16% fall.

 

"When
bad news drives these stocks down, it makes them more compelling," says
David Bianco, head of U.S. equity strategy at Bank of America Merrill
Lynch. He notes that as a group, big tech has gained just 4.0% this
year, versus 6.6% for the entire sector, and carries a P/E of about
12.8, versus about 16.7 for the others.

 

The key advantage big
tech outfits hold, says Mr. Bianco, is their strong balance sheets,
which should help them boost earnings even if growth slows. "They will
issue bonds, buy back shares and acquire other companies," he says.
"Large tech will benefit from that."

 

Go-Anywhere Funds

 

Investors
who wish to take some profits on stocks and redeploy it elsewhere
should consider "tactical allocation" mutual funds that allow managers
to jump into and out of asset classes at will.

 

When the stock
market trades in a band, as it has for the past decade, these sorts of
funds can perform well. According to data from investment-research
firm Morningstar Inc. through October, "world allocation" funds have
returned 5.08% annually over the past five years and 5.78% annually
over 10 years, compared with the S&P 500's 1.73% annualized gain
over five years and an annualized loss of 0.02% over 10 years.

 

Some
tactical funds handily beat traditional equity funds during the
financial panic. "There were many investors in 2008 and 2009 who were
disappointed by how little their fund managers could do to react to or
react ahead of what was developing," says Loren Fox, senior analyst at
research firm Strategic Insight.

So far this year, financial-services firms have launched 28 world allocation funds, according to Morningstar.

 

Steven Roge, a portfolio manager in Andover, Mass., has been moving
more of his clients' money from traditional equity funds to flexible
funds—such as IVA Worldwide Fund, Pimco Global Multi-Asset Fund and FPA Crescent Fund,
among others—because of the managers' ability to make swift
asset-allocation decisions and their use of derivatives to reduce risks.

 

"Asset allocation plays such a big part in the return of the
portfolio that we could probably add 2% to 3% more in returns with less
downside just from the timeliness of the shifts in asset allocation,"
says Mr. Roge, who estimates that about 40% of his clients' portfolios
are in flexible funds, up from about 12% a few years ago.

 

The Goldman Sachs Dynamic Allocation Fund,
launched in January, aims to shift between asset classes based on
volatility. If, for example, the volatility of the S&P 500
increases, the fund would pare stock holdings.

 

"By taking some
risk off the table as asset-class risk increases, that potentially
sidesteps some of the downward movement in the market," says Theodore
Enders, portfolio strategist at Goldman Sachs Asset Management.

 

Tactical funds can be unpredictable. The $25 billion Ivy Asset Strategy Fund,
for example, held an 80% net equity position at the beginning of 2010,
then pared it back to 18% at the end of February, only to ramp it up
again a few months later.

 

"If you have a fund that's changing its asset
allocation frequently, it can be difficult to know how to position the
other funds in your portfolio," says Kevin McDevitt, a Morningstar
analyst.

 

Note, also, that fees for these funds can be high. The Direxion Spectrum Global Perspective Fund, for example, has annual expenses of 2.55%.

Rising-Rate Funds

 

A
typical move after a powerful stock rally is to sell shares and buy
bonds. But with the Treasury markets surging to record highs recently,
putting more money there could be even riskier than leaving it in
stocks.

 

The Fed is buying Treasurys
now, but not all maturities. When it said last week it would avoid
30-year bonds, their prices promptly tanked. That could be a hint of
what's to come once the Fed stops buying other maturities. Its ultimate
goal, after all, is to juice the inflation rate. Rising inflation is
usually bad for bonds.

 

Instead of Treasurys, investors should
consider "floating rate" funds, which buy variable-rate corporate
loans—and therefore collect more money when rates rise. In 2003, for
example, when the Fed started raising rates, floating-rate funds gained
10.4% while short-term bond funds gained 2.5%, according to
Morningstar.

There are at least 31 open-end funds and 10 closed-end funds to choose from. Morningstar's picks in this category include the Eaton Vance Floating-Rate Fund and the Fidelity Floating Rate High Income Fund, which boast experienced management teams and solid track records.

 

Warren Ward, a financial adviser in Columbus, Ind., says he is considering the Fidelity Advisor Floating Rate High Income Fund
for his clients because of manager Christine McConnell's experience
through up and down markets. Another plus: The fund holds a considerable
amount of cash, which should allow it to meet any redemptions without
having to sell securities, he says.

 

"If rates rise,
floating-rate funds offer investors some protections," says Mr. Ward.

 

"I would like to say go into bonds to get yourself out of stocks, but I
think they're more risky right now."

Bonds are a hell of a lot more risky right now, but as Randall Forsyth of Barron's notes, Bonds Are Not Dead Yet:

Bond
yields continued to climb last week even as the Federal Reserve began
its bond-buying operation known as QE2. As the U.S. central bank began
the second phase of its quantitative easing, heavy new-issue supplies
in all sectors encountered buyer resistance.

 

The
result was a rise in yields, especially for longer maturities, of
about 45 basis points (0.45 percentage points) from their lows of early
October, with about half of the increase coming in the past week alone.
That translated into price losses upward of 2%, roughly equal to the
give-back in the stock market.

 

In
the Treasury market, the 10-year- note's yield rose to 2.776% from
2.538% a week earlier and a low of 2.332% on Oct. 8, the low-water mark
since January 2009, Dow Jones Newswires notes. Meantime, the 30-year
bond yield rose to 4.274% Friday from 4.122%, in part because of weak
demand at Wednesday's auction of the issue.

 

That sounds relatively trivial but it resulted in the price of iShares Barclays 20+ Year Treasury Bond exchange-traded
fund (ticker: TLT), a popular way to participate in the long end of
the market, falling 2.2% on the week. Even the less volatile iShares Barclays 7-10 Year Treasury ETF (IEF) lost 1.4% for the week.

 

The
corporate market also buckled under the weight of $21 billion of new
issues in the first three days of the week, prior to the Veterans' Day
holiday, and is bracing for $25 billion of offerings this week. The
iShares iBoxx $ Investment Grade Corporate ETF shed 2% in sympathy.

 

The
municipal market was hit as well with yields of triple-A 20-year bonds
up over 20 basis points to around 3.70%. As a result the iShares S&P National AMT-Free ETF
(MUB) was down 2.3% on the week. Some closed-end muni funds were
pummeled by upward 7%-10%, according to Jerry Paul, who heads Essential
Investment Partners in Denver, which specializes in closed-end-fund
special situations. Closed-end funds' use of leverage makes them
inherently more volatile. Moreover, many had been bid up to large
premiums. Still, growing disquiet over municipal finances cast a pall
over the sector.

 

But even if the
bull market in bonds is dead, as declared the Bond King, otherwise
known as Bill Gross, the founder and co-chief investment officer of
Pimco, the manager of the world's biggest bond fund, there's an upside:
higher yields.

 

The end of the bull
market does not necessarily mean a bear market has started, counters
James Kochan, a bond-market veteran whose career predates the beginning
of the bond bull market and is now chief fixed-income strategist of
Wells Fargo Advantage Funds. With inflation and short-term interest
rates likely to remain low, bonds outside of Treasuries still provide
value, Kochan says. "This is the income phase of an income-investment
cycle, not the bear phase—yet," he adds.

 

That means looking to
sectors of the bond market where income returns more than offset the
risk of rising yields and falling prices. In the corporate sector, that
means the high end of high-yield market with credit ratings of
single-B or double-B, which provide respective yield spreads of 475 and
375 basis points. More speculative credits, with ratings of triple-C,
don't offer commensurate value.

 

Municipal
bonds also offer good value and income, Kochan adds. He prefers longer
maturities because of the steep muni yield curve (that is, long bonds
yield a lot more than those with shorter maturities). For instance,
30-year triple-A munis yield 4.20%, markedly more than 2.56% for
10-year bonds or 1.18% for five-year bonds.

 

Instead
of triple-A credits, he prefers the yield pickup in the single-A to
triple-B muni credits. For 10-year maturities, extra yield equals 100
basis points for single-A bonds and 150 basis points for triple-Bs. For
30-year maturities, the spreads are 250 basis points for single-A
credits and 400 for triple-Bs. Quality spreads, already wide this
year, have increased in the past couple of weeks, Kochan notes.

I'm not so sure about the municipal bond market where systemic credit risk is very high,
causing a great deal of anxiety among bond investors. But at the end of
the day, the Fed will do whatever it takes -- even buy municipal bonds
-- to head off any systemic crisis.

As far as the stock market, I just see this as another opportunity to
load up on shares. My personal favorites remain Chinese solar stocks
which sold off strongly after most reported stellar earnings. One of my top picks in this group is LDK Solar, which smashed its estimates and then sold off (warning: these stocks are not for the faint of heart).

Tim Hayes, chief investment strategist at Ned Davis Research, spoke
with Carol Massar and Matt Miller on Bloomberg Television's "Street
Smart" saying he expects a 3-5% correction in stocks in the next few
weeks (click here to watch the interview).
Hayes is one of the best strategists in the business and a super nice
guy. I think he's probably right. It's only normal for portfolio
managers to lock in profits going into year-end, but I warn you, if you
think this the beginning of some sort of systemic collapse, you're in
for a big surprise.

This market is heading higher -- much,
much higher. And all of you trying to time these markets will get your
heads handed to you. Buy and hold maybe dead for the overall market, but
it certainly isn't dead for some sectors and stocks. If you pick your
spots well, you'll make decent profits as this rally still has steam.
The only thing is you need to accept a lot more volatility. There is is
nothing you can do about that.