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Stock Market Strategy- Pay Attention

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We’re moving into the later stages of a remarkable, five -year stock market rally, fueled by low interest rates and strong corporate profits. The S&P 500 is at an all-time high while the world seems to be on the brink of crisis; with unrest in Ukraine, Russian sanctions, an Ebola outbreak, weaker economies in Europe and the ongoing problems in Syria and Iraq. The stock market’s ho-hum response to what is happening around the world makes sense if there isn’t another attractive investment alternative.

It’s now been five years since a major market correction. The US economy is still in recovery mode and corporate earnings are strong. Buying on the dips is still the norm and volatility is very low. Is a correction on the horizon? No, don’t expect a correction of the 2008 magnitude. However, a moderate market decline depends on what happens with interest rates and the relative attractiveness of other asset classes. Stocks are still more competitive than 10 year Treasury notes at 2.50%.

Economic growth and corporate earnings also play a key role in deciding if this rally continues. If companies continue to report high single digit growth in earnings and interest rates are low then stocks will remain attractive. Investor sentiment is also important. There’s a large crowd of nervous investors waiting for the next correction who remember all too well the carnage of 2008. This nervousness is actually positive for the market. Worry when everyone forgets 2008 and throws in the towel and buys stocks. This isn’t happening. So the answer to the question is that a major correction is not on the horizon but periodic pull backs are likely. The economy is reasonably strong, interest rates will rise but not dramatically and corporate earnings show no sign of weakening. The problem with this conclusion is that everyone agrees with it.

The things we worry about never happen; it’s the things we never think of that do. In other words, we don’t know what is in store for the world economies and the Federal Reserve will determine the course of interest rates. There is plenty to worry about but this should not dictate investment strategy. There may be a shock on the horizon but we can’t make decisions on what we don’t know. What we do know is that stocks have had a remarkable run and it may be time to take profits and hold a little more cash than normal. Market timing doesn’t work, but reducing large positions that have done well is a conservative strategy as the market rally ages.

It is best to be early rather than wrong. It is unlikely that high multiple growth stocks will continue to move higher indefinitely. Investors will refocus their portfolios on companies with more stable earnings as the market rally enters the later innings. It makes sense to trim positions that are higher risk or trading at very high historic multiples. Experts have been expecting a correction for two years and investors who believed them have regretted it. As time moves on and stocks don’t retreat we will most likely end up with a correction. However, gradual trimming rather than wholesale selling is always a better strategy, unless any of us are smart enough to know what the catalyst for the next correction will be. Chances are if we are talking about it stocks have already priced it in.

So, pay attention to the Fed narrative around interest rate increases and the competitive returns on other investments, watch earnings projections as we approach 2015 and stay disciplined and avoid fads. The stock market is more vulnerable after such a long rally and earnings have to grow to justify further gains. Peter Lynch said “the way to make money in stocks is to not get scared out of them”. No matter how frightening the world appears it is almost always a mistake in the long run to over react. On the other hand, complacency can mean surprises down the road.