The Death Knell for the Stock Market

This article is published with permission from InvestmentU.com.

Investment legend John Templeton famously said that bull markets are born on pessimism, grow on skepticism, peak on optimism and die on euphoria.

The last 13 years confirm just how right he was — and also show why smart equity investors should start pulling in their horns now.

Your own experience will easily confirm it…

Think back to 1999. We were in the midst of one of the biggest financial bubbles in the nation’s history: the Great Technology and Internet Stock Blowout. Shares soared to stratospheric levels despite a paucity of earnings and — in many cases — even sales. Yet investors kept repeating that we were in “a New Era” and that “the Internet changes everything.”

Indeed, the Internet did change everything. But that is no justification for paying insanely high prices.

From its all-time peak of 5,046 on March 10, 2000, the technology-heavy Nasdaq plunged 78% to 1,114 by October 2002. The leading index of Internet stocks plunged 90% over the same period.

The real estate bubble was next. Less than 10 years ago, housing speculators and condo flippers assured us that “real estate always goes up,” despite the fact that it had fallen in Japan every year for the previous 14 years.

They also noted “they’re not making any more land,” something that has been generally true since the oceans last receded in the Miocene period about 23 million years ago. Funny how the finite nature of land rang a bell with some folks only after home prices tripled in seven years.

Each bubble ended with a decided bust.

The new bubble?

Now the bull market that began in March 2009 is getting a little frothy. In a front-page article titled “Stocks Regain Broad Appeal,” The Wall Street Journal reported recently that mom-and-pop investors have finally gathered the confidence to start investing in stocks again.

Uh-oh.

These are the same folks who — following the recent financial crisis — either sat on their hands or bailed out in a panic as the market offered up some of the very best buying opportunities of our lifetime.

Great companies sold at single-digit P/E ratios. High-quality real estate investment trusts and corporate bonds sported double-digit yields. Yet, anxious and afraid, they would have none of it.

Now, after the broad averages have more than doubled, P/E ratios have soared and dividend yields have wilted, they want back in.

Just as Templeton predicted, we went from pessimism four years ago, to skepticism two years ago, to optimism today.

That doesn’t mean the bull market is over. After all, we still haven’t hit euphoria yet. (That’s the point where the folks who are piling in now start bragging at cocktail parties about how much their stock portfolios are up. That’s when the death knell always tolls. And we may be as much as another couple of years away.)

Do this today

What should you do? Start with checking your asset allocation. After several years of rip-roaring stock market returns, you may have more in stocks than you’re comfortable with.

Benjamin Graham, the value investor who was the primary mentor to Warren Buffett, advised that no investor should ever have less than 30% of his portfolio in stocks or more than 70%. Still sound advice.

Also, don’t neglect your trailing stops. During bull markets, every sell-off is just a brief correction. After a while, investors start thinking it’s silly to risk getting stopped out of a good stock.

After all, everything bounces back after a couple weeks. Right?

Wrong. These are the folks who will get their heads handed to them in a real secular bear market. Don’t be one of them. Trailing stops offer you unlimited upside potential with strictly limited downside risk. That’s an appealing proposition.

In short, valuations and sentiment show that we have moved from skepticism to optimism. Euphoria is next. And while it may take a while to get here, it’s coming.

The question is: Will you be ready… or flattened?

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.