Optimism among investors is common when benchmark indexes show continued strength. But often a bull-run is followed by a drastic breakdown. Those with foresight spot the turning point and equip themselves with strategies to benefit. Others incur a huge loss or wait long for a rebound.
Have you ever calculated how much money you could have protected with a cue to the 2008 sell-off?
It would be foolhardy to sell all your stocks that have further gains latent simply on speculations of a market crash but you can minimize your portfolio risk if you get a clue. Of course your investment strategy is a function of your risk appetite, but who likes to lose money?
First judge whether the bull run is supported by economic, political or other key drivers. Then check if the market is overbought and thus overvalued. Also, pay good attention to realistic market rumors. (Read: Making Sense of This Market )
Is Now the Time to Think This Way?
Major U.S. stock indexes hit their all-time highs, crafting around 100% over a five-year time span (since 2009). Doesn't this fast-forward growth of the stock market looks unusual given the slow pace of economic recovery, and lingering internal and external issues? Almost all economic indicators save the stock market (a not-so-good indicator though) are also yet to return to their pre-recession peak.
There are enough arguments in favor of the continuation of this bull-run too; but the bears are perhaps gaining strength to dominate the near future. Speaking rationally, the market's behavior won't be so different from what the economy indicates.
Let's see what the key indicators of a looming market crash are:
Low Volume of S&P 500
When the index hit an all-time high last month, the average daily volume was the lowest since 2008 at about 1.8 billion, according to Bloomberg data. This is because the upsurge of only a few stocks lifted the index to its all-time high. Others saw dreary trading with investor skepticism surrounding the underlying strength.
According to the Bloomberg data, only about 20 of the index's 500 members reached their 52-week high the day it hit the all-time high.
Historically, an upsurge like this with low volume has ended up in a crash.
"Warren Buffett Indicator" Points to Overvalue
Billion-dollar investor Warren Buffett's stock market valuation metric is at a very high level, indicating that the market is overvalued. So a sell-off might be imminent.
The metric is calculated by dividing the entire market cap of all equities by quarterly gross national product, or GNP. Generally, the ratio below 1 indicates that the market is undervalued, and hence a buying opportunity. But the higher it is from 1, the more overvalued the market is, thus creating selling pressure.
Higher Cash Holding by Money Managers
A survey conducted by Bank of America Merrill Lynch in the beginning of May shows that fund managers across the globe held average cash of about 5% of their portfolio. This is the highest level of cash holding since the height of the Eurozone sovereign debt crisis in June 2012. This indicates that money managers are taking a risk-averse approach as they are skeptical about the ballooning stock market.
Feeble corporate earnings backdrop and continued liquidity reduction through tapered bond buying by the Fed stand out among the fundamental factors that might reverse the direction of benchmark indexes.
On the other hand, Treasury yields continued to plunge, spreading investor pessimism on economic growth. According to the Commerce Department's second estimate, U.S. GDP shrank at an annual rate of 1.0% in the first quarter, reflecting the worst performance in three years. This should ultimately get reflected in the stock prices.
How to Prepare Yourself
It is perhaps not a smart idea to liquidate all your stock holdings and wait for the storm to get over, as some of your stocks might still go a long way and more than offset the loss you expect if the market crashes. But risking everything will not be a prudent decision either.
So the best course, irrespective of your risk appetite, would be to book profit on those that don't have the potential to gain further. But if you are a risk-averse investor, you should consider booking as much profit as your portfolio permits. In such a case, you may not earn the extra profit that the best stocks of your portfolio might give you, but there will be no risk of losing virtually all that you have today.
If you are not afraid of taking risks, you should stay invested in the stocks that still have the potential to move north. Also, you may look for fresh bets for turning the odds in your favor.
In any case, booking profit on stocks that no longer hold upside potential would help you minimize risk.
3 Stocks to Book Profits
I ran a screen on Research Wizard with the following criteria:
- Change in this year's estimate over the last 4 weeks less than or equal to -20%: Stocks with such a huge downward earnings estimate revision generally experience the greatest price decline.
- Price change year-to-date greater than or equal to 15%: This selects stocks that will give you at least 15% profit if you are holding them since the beginning of the year.
- Zacks Rank greater than or equal to 4: This finds out stocks that don't have further growth potential. Stocks with these ratings have historically witnessed a price decline.
- Zacks Industry Rank greater than or equal to 177: This selects stocks from industries with a 'negative' outlook. To learn more visit: About Zacks Industry Rank .
(See the performance of Zacks' portfolios and strategies here: About Zacks Performance) .
Here are 3 of the 5 stocks that passed through the screen:
Palo Alto Networks, Inc. ( PANW ): Headquartered in Santa Clara, CA, this Zacks Rank #5 (Strong Sell) stock is a network security platform provider in the Americas, Europe, the Middle East, Africa, the Asia-Pacific and Japan. The platform comprises Next-Generation Firewall.
% Change F1 Estimate (4 weeks) = -31.3%
% Price Change (YTD) = 28.2%
Zacks Industry Rank = 190
Century Casinos Inc. ( CNTY ): This casino entertainment company is based in Colorado Springs, CO. The company is engaged in developing and operating gaming establishments and related lodging, restaurant, and entertainment facilities worldwide. It holds a Zacks Rank #4 (Sell).
% Change F1 Estimate (4 weeks) = -25.9%
% Price Change (YTD) = 17.1%
Zacks Industry Rank = 186TG
Therapeutics, Inc. ( TGTX ): This Zacks Rank #4 biopharmaceutical company is based in New York. It primarily focuses on the acquisition, development and commercialization of various pharmaceutical products for the treatment of cancer and other underserved therapeutic needs.
% Change F1 Estimate (4 weeks) = -24.3%
% Price Change (YTD) = 70.5%
Zacks Industry Rank = 179
Don't Wait to Pull the Trigger
No matter how the stock market turns out, you should not wait to get rid of stocks that are running out of steam after burning bright. Sell them right away and stay in cash. The market might give you attractive entry points to your desired stocks in the next few months. On the other hand, I won't discourage you from taking fresh bets, but only look for stocks from industries with a positive outlook.
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