Investors Are Making This Classic Mistake -- Again

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Few would mistake the currentmarket action with what we saw back in 2000, but it's increasingly clear that investors have become conditioned to ever-risingstock prices.

The S&P 500 has posted a very impressive rebound over the past 17quarters . In fact, over the past 20 months, the S&P 500 has risen 46%, which is what investors should reasonably expect from the market over six or seven years.

There's no shame in staying involved in abull market , as long as you show a great deal of discipline. An ever-rising market requires you to start trimming the more aggressive and risky portfolio holdings, maintaining a focus onstocks andfunds more likely to hold their own when the inevitablemarket correction comes.

"The line separatinginvestment andspeculation , which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortlessmoney ."

Buffett made those comments back in 2000. Since then, he has repeated a simple notion: If you want to score solidgains , avoid the crowd when it comes to the most popular investment trends of the moment -- focus instead on unloved stocks and sectors.

Chasing Success

Few investors are heeding Buffett's words. A review of thisyear 's most popular exchange-traded funds ( ETFs ) shows that investors are pouring their money into what has already been working in recent years and pulling money out of underperforming ETFs.

For example, as the market has risen, volatility has virtually disappeared. TheVIX , a key measure of expected market choppiness, has fallen from above 80 in late 2008 to above 45 in the summer of 2011 to a recent 13.

ETFs thatprofit from low volatility have attracted more than $5 billion this year in new inflows, with one-third of that coming in April, according to BlackRock. In effect, investors are now betting on volatility to fall further, even as this investment angle appears to have largely played out.

Can volatility go lower? Not very much. In 2007, theVIX 's 20-year low was registered at 10.5. The potential rebound for the VIX, on the other hand, is open-ended.

Or take the suddenly popular Japanese market as an example. My colleague Jim Woods pointed out the appeal of the WisdomTree Japan HedgedEquity ETF ( DXJ ) at the end of 2012.

Thefund has since risen a stunning 65%.

Trouble is, investors are still pouring money into this ETF. According to S&PCapital IQ , this fund has been the topasset gatherer this year with $5.3 billion in inflows. The iShares MSCI Japan ( EWJ ) is close behind with $4.2 billion. Investors are chasing success, which is precisely what they did in U.S. markets in late 1999 and 2000.

Of course, many other foreign markets aren't faring nearly as well. The United States, Europe and Japan have delivered great returns this year, but manyemerging markets have risen only modestly. For instance, the iShares MSCI Emerging MarketsIndex ( EEM ) has fallen 2% this year.

How have investors responded to that underperformance?

They've pulled $5.4 billion out of that fund in 2013, according to BlackRock. Yet the relative underperformance of emerging market stocks and funds has led to a clear valuation gap. The trailing 12-month price-to-earnings (P/E ) ratio on all of the emerging markets held in the iShares ETF now stands at just 11, well below the P/E of 15 for the S&P 500.

My point: If investors arebullish on the globaleconomy , they should be buying the currently unpopular emerging-market funds.

In a similar vein, investors have been beating a hasty retreat from commodities-focused ETFs: In April, more than $8 billion was pulled from these funds, according to S&P Capital IQ.

Roughly a month ago, I took note of the sharp sell-off in commodities and at the time, noted that "lower prices counterintuitively set the stage for the next bull market in commodities," as supply is reduced and pricing starts to strengthen anew. It's a bit premature tospot acommodity rally just yet, butcontrarian investors would do well to start sharpening their pencils in this investment niche.

The Fixed-Income Conundrum

Investors' need for income-producing stocks and funds is understandable. Withbond yields from blue-chip issuers such as IBM ( IBM ) and Coca-Cola ( KO ) offering yields below 3%, investors have instead been focusing squarely on thedebt issued by less creditworthy corporations.

These kinds ofbonds are called "junk" for a reason. They carry a higher risk ofdefault , though we've seen few majorbankruptcies recently. Still, the ardor for these higher-yielding riskier bonds has led to a furious rally, pushing the historical yields from the 6% to 8% range to below 5%.

That's the result of billions pouring into high-yielding bond funds such as the PIMCO 0-5 High YieldCorporate Bond Index ETF (HYS) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) . At some point in this economic cycle, thesehigh-yield bonds will experience risingdefaults , which could well lead to a furious exit from this riskier corner of thefixed-income market.

Risks to Consider: Some of these ETF niches are in a mania phase, which can last for an extended period, so it's unwise to short them until clear signs of a market shift have emerged.

Action to Take --> The main lesson isn't that you should avoid this market. Instead, you should avoid its most popular niches and redirect assets into unloved niches, such as emerging markets and commodities. I remain a big fan of automakers and their suppliers, along with insurers, as they represent deep value in this rising market.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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