What to Do with This Rally?

by: FXedu

By Anders Geertsen

I recently wrote about the stock market and ETFs. At the time of the first post (3/23) the S&P was around 750, and I recommended that the long term investor get back in the market. At the time of the second post (4/6) the market was at 820, having surged almost 10% in a matter of only two weeks. My comment on the market back then was: “At this level, I think the market is still relatively a good value”.

Now the market is up even more. Currently the S&P is at 870. That means it is up about 30% from its bear market low of 670 on March 9. Quite a rally and the question is:

Is this sustainable?

You can’t get a straight answer to this question from anyone. Some people will tell you to get out and others will tell you that we are in the early phases of a major bull run. What this illustrates is how hard it is for the average investor to “beat the market” and time when to get in and out of stocks.

Many active money managers will claim they have superior skills and magic crystal balls that tell them when to buy and sell. But the fact is most of these managers underperform the market in the long run. So as a general rule I recommend the average investor to stay away from active money managers and mutual funds which are expensive and provide little real value.

For those who like to study the market in a historical perspective, one of the most prominent valuation tools is the so-called 10-year Shiller P/E, named for Professor Robert Shiller at Yale. This measure smoothes out the earnings cycle over a 10-year period and this way avoids the bumps that the 12-month trailing or forward P/E has. The 10-year Shiller P/E is around 60 on S&P operating earnings.

So with the market at 870, you have a P/E of 14.5 That is a quite reasonable number; in fact it is slightly under the 200-year average of 16.

Historically, for those who invested at times when the Shiller P/E is below 16 the returns have been good. Professor Shiller ran the numbers and in this respect “good” means a 7-10% yearly return, which is what you can probably expect in the long run.

Some investors sold out in a panic around the beginning of March as the market tanked. Those people are now sitting on heavy losses and on top of that have missed a 30% market rally. The lesson is age old and yet investors keep missing it: Do not let the market’s mood swings dictate your investment strategy!

The market is like an irrational drunk who stumbles along in the alley trying to get home from the pub. He will make wild swings back and forth but he will eventually get home. Keep that in mind as you grow your own investments!

If you put money in the market at regular intervals (so-called “dollar cost averaging”) and stay properly diversified (by using ETFs) and stay away from expensive active managers and mutual funds who promise to “beat the market” you are well on your way to a sensible investment strategy.

This brings us back to the initial question: What to do with the rally? I can tell you what I have done. Mostly, I have done nothing. I simply do not believe I have superior market timing skills so I am not going to bet my portfolio on that assumption.

As you know, I recommend the average investor (with a million or less in liquid assets) use low cost ETFs to diversify. For those who like to speculate in individual stocks I recommend you limit this to a very small part of your portfolio. I have a small portion set aside myself for individual trades and here I have sold a little bit.

I had one stock which I thought was getting thrown out with the bathwater during the mayhem in the beginning of March. Whether due to luck or skill (probably luck), this stock has now quintupled and I sold it all. But it only represents about 5% of my portfolio and that is the only trade I have made.

I sold the particular stock because it is a financial stock and I am still uncomfortable with the health of the US and European financial sector. I also think the housing market has another nasty leg down (more on that in my next article) and banks will suffer in that scenario. In the rest of my portfolio I stick to ETFs which are low cost, diversified and let me sleep at night.

Overall I keep buying a diversified basket of stocks in my 401(k). Every month I max out the contribution to get the tax deduction and employer contribution. This is money that I won’t touch the next 20-30 years and with the market at a current P/E of 14.5 I am confident it will provide a nice return. This is my way of staying disciplined and following the three rules:

  1. Use dollar cost averaging (add a fixed amount every month or so).

  2. Diversify by using low cost ETFs.

  3. If you look at valuations, use the Shiller 10-year P/E and buy when below trend.

Original article