Time To Be Fearful When Everyone Is Greedy

 |  Includes: BP, BRK.B, F, STO
by: Jacob Steinberg

The market has a bad habit. It tends to punish investors whenever they grow too comfortable with it. Remember the years ranging from 2003 to 2006 and how experts were constantly on TV telling people house prices can only go up? How about in 1999 when internet stocks were considered to be the safest investments that "have no chance of" failing? Even last summer was an interesting example. Whenever investors grow too comfortable with the market, it always punishes them one way or another.

Most of the problems that caused the volatile stock market last summer were not solved. U.S. debt is still a huge mountain that's nearly impossible to climb. European debt is still a huge monster that is ready to consume the continent. Japanese economy is still struggling and even economies like China are having trouble growing as we speak. Gas prices are too high, house prices are too low (historically speaking) and this is the perfect recipe for disaster in an economy.

Indeed some of the acute problems of the economy became chronic and the investors just "learned to live with it." Nowadays, it takes more than average bad news to bring the markets down, but this may not continue forever. Just like the economy, the stock market also works in cycles. Remember Warren Buffett's well-known saying, "fear when everyone else is greedy and be greedy when everyone else is fearful."

A common wisdom in the stock market dictates that the end of a bear market is marked by the average person giving up on the bear market and the end of a bull market is marked by the average person joining the bull market. When most bulls turn bear, the bear market is said to have come to an end, and when most bears turn bull, the bull market is said to have come to an end.

Currently most indexes are at or near their all-time highs, retail investors are back to market, bondholders are selling their bonds to buy more stocks, NBC and Bloomberg tv talk about how rosy things look, many "experts" talk about how Dow 20,000 is possible, analysts are raising their ratings to "strongly buy" or "buy" for 95% of the stocks they cover, bank stocks are rallying even faster than the rest of the market, and all the economic problems are already forgotten and have become noise in the background. These are usually signs of the nearing end of the bull market. All these happened back in 1999 and 2007.

If a correction is due soon, what can investors do? There are ways to protect one's portfolio in case a correction occurs. Personally, half of my portfolio is composed of dividend stocks. Also, I sell calls in most of my stocks as protection in case they go down. So far, it has helped greatly.

For those who are looking for a defensive approach, I suggest stocks with consistently high dividend yields in addition to stocks with historically low P/E values. Those stocks usually have very little room to go down. For example, Ford's (NYSE:F) P/E ratio of 2.56 currently makes it a defensive play even if the company doesn't fit the typical definition of "defensive stock." I can't imagine Ford having a much lower P/E ratio.

Another defensive play would be Berkshire Hathaway (NYSE:BRK.B). This company also enjoys historically low P/E ratios and doesn't have much room to fall. I would also suggest an oil company with low P/E such as BP or Statoil (NYSE:STO), not only because they are defensive, but also because they will benefit greatly from current oil prices.

I know it is very difficult to resist the temptation of going with the flow. I remember one of my friends passionately preaching to me about buying a couple houses for investment back in 2006. When the market is constantly going up, it is so easy to grow comfortable with the idea and forget that the market can also go the other way. I am not suggesting selling all of your growth stocks, however I am suggesting you find a way to balance your portfolio and prepare for the worst whether your method is writing options or relying on dividends.

Disclosure: I am long BP, F.