Dow and S&P Reach Milestones: Bubble Fears Arise

The Dow pierced the 16,000 level for the first time ever - and perhaps more impressively, it made the jump from 15,000 to 16,000 in just six months. The S&P 500 poked above 1800 in less than 4 months after taking out 1700. To put the rapid rise into context, after first reaching 1500 in March 2000, it took the broad index 13 years to reclaim that level. For tech fans, the NASADAQ recently touched 4,000, a level not seen since September of 2000. Although the economy has improved and corporate profits continue to surpass expectations, the Federal Reserve is responsible for the lion’s share of the stock market’s move higher over the past year. Without low short-term interest rates (0 to 0.25 percent since December 2008) and $85 billion worth of monthly bond buying, it’s hard to build a case where stocks would be at these levels.

But we are where we are. The S&P 500 is up 26 percent this year and has risen by 166 percent since the March 2009 lows, which means that bubble fears are arising anew. The bears point to troubling signs, including: ordinary investors are finally buying back in -- money is pouring into stock mutual funds and exchange-traded funds at the highest rate in four years; investor sentient has become almost uniformly optimistic; borrowing to purchase stocks is at record levels; and the main gauge of investor fear is low. Some warn that taken together, investors are becoming complacent, setting everyone up for a correction, which is a pull-back of more than 10 percent.

But just because a correction could be coming, does not mean you should bail out. If you are a long-term investor with a 15 or 20-year time horizon, there is no reason to alter your game plan – use the new highs to rebalance and keep investing in a diversified portfolio. But if you are the kind of person who simply cannot handle the ups and downs of the stock market, remember that just because stocks are higher, does not make them any safer. Please use caution before jumping back in!

Even if new milestones don’t really mean too much, I am happy to use them as an opportunity to remind you to review where you stand, create a target allocation and force yourself to rebalance according to your goals.

Here's what smart money has known forever--the quicker you learn these rules, the better:

Don’t let your emotions rule your financial choices. There are two emotions that tend to overly influence our financial lives: fear and greed. At market tops, greed kicks in and we tend to assume too much risk. Conversely, when the bottom falls out, fear takes over and makes us want to sell everything and hide under the bed.

Maintain a diversified portfolio. One of the best ways to prevent the emotional swings that every investor faces is to create and adhere to a diversified portfolio that spreads out your risk across different asset classes, such as stocks, bonds, cash and commodities. (Owning 5 different stock funds does not qualify as a diversified portfolio!)

Avoid timing the market. Repeat after me: “Nobody can time the market. Nobody can time the market.” One of the big challenges of market timing is that requires you to make not one, but two lucky decisions: when to sell and when to buy back in.

Stop paying more fees than necessary. Why do investors consistently put themselves at a disadvantage by purchasing investments that carry hefty fees? Those who stick to no-commission index mutual funds start each year with a 1-2 percent advantage over those who invest in actively managed funds that carry a sales charge.

Limit big risks. If you are going to make a risky investment, such as purchasing a large position in a single stock or making an investment in a tiny company, only allocate the amount of money you are willing to lose, that is, an amount that will not really affect your financial life over the long term. Yes, there are people who invest in the next Google, but just in case things don’t work out, limit your exposure to a reasonable percentage (single digits!) of your net worth.

Ask for help. There are plenty of people who can manage their own financial lives, but there are also many cases where hiring a pro makes sense. Make sure that you know what services you are paying for and how your advisor is compensated. It’s best to hire a fee-only or fee-based advisor who adheres to the fiduciary standard, meaning he is required to act in your best interest. To find a fee-only advisor near you, go to NAPFA.org.

For those who want to protect their portfolios against the eventual rise in interest rates, you may be tempted to sell all of your bonds. But of course that would be market timing and you are not going to fall for that, are you? Here are alternatives to a wholesale dismissal of the fixed income asset class:

Lower your duration. This can be as easy as moving from a longer-term bond into a shorter one. Of course, when you go shorter, you will give up yield. It may be worth it for you to make a little less current income in exchange for diminished volatility in your portfolio.

Use corporate bonds. Corporate bonds are less sensitive to interest-rate risk than government bonds. This does not mean that corporate bonds will avoid losses in a rising interest rate environment, but the declines are usually less than those for Treasuries.

Explore floating rate notes. Floating rate loan funds invest in non-investment-grade bank loans whose coupons “float” based on the prevailing interest rate market, which allows them to reduce duration risk.

Keep extra cash on hand. Cash, the ultimate fixed asset, can provide you with a unique opportunity in a rising interest rate market: the ability to purchase higher yielding securities on your own timetable.