Caution: Right Now the Market is Telling Us to Be Careful

Humans love stories.

They like to turn complex ideas into simple stories.

The stock market is a perfect example. It doesn’t actually tell stories… It’s just a place where millions of investors go every day to buy and sell shares of businesses. But humans can’t help but think about the market as if it were telling them a story with every tick up or down.

[ad#Google Adsense 336×280-IA]Every market participant tells himself a bullish, bearish, or neutral story.

Add them all up, and you get one big “mega story.” That mega story is what we call “the prevailing bias” (a term I stole from legendary investor George Soros and redefined for my own purposes).

Over the past couple years, the prevailing bias has been bullish. That seems to be changing…

Last year was a minefield that led to the stock market’s worst performance since 2008 (which we largely avoided).

But many stocks are still expensive, and the market is still way up over the past seven years.

There’s more fear in the market today than there was a year ago. Stocks are cheaper, and there are far fewer bullish investors. But that doesn’t mean there are a lot more bearish investors. Instead, the majority of investors are neutral about the stock market…

The American Association of Individual Investors (AAII) Sentiment Survey showed 51.7% of investors surveyed were bullish at the start of 2015 versus just 25.1% bullish today.

It showed 22.3% of investors were bearish at the start of 2015 versus 23.6% bearish today.

And it showed 51.3% of survey participants are neutral on stocks now, neither bullish nor bearish, versus just 32.7% neutral a year ago.

Investors looking in their rearview mirror at last summer’s 13% plunge in the S&P 500 feel more scared than they did last year. But because the market has recovered somewhat in the last couple months, it has taken the edge off their fear.

Here’s where we stand today…

Many stocks are still unattractive… even though investors are less bullish and last year’s poor market performance made some stocks relatively more attractive than they were a year ago.

The prevailing bias is weakening. The combination of a weakening prevailing bias and still-expensive stocks means you have to be careful.

Some people like to be careful by selling short the shares of weak companies. Others prefer to hedge their portfolios with put options, like buying insurance against a market drop. But there’s a much easier way to reduce risk in an equity portfolio…

By far the easiest, safest, most certain way to reduce risk in an equity portfolio is to hold plenty of cash. As I showed you in this DailyWealth essay, the optionality of cash isn’t priced in a large, liquid market. There aren’t millions of people trading it back and forth millions of times a day. It has no expiration date. And you aren’t locked into buying or selling at a particular time.

Right now the market is telling us to be careful… Making sure you have plenty of cash on hand is the best way to prepare.

Good investing,

Dan Ferris


Source: Daily Wealth