Even in this market, don't forget to be disciplined

It's a good time to remember Buffett's golden rule.

By StreetAuthority May 17, 2013 10:41AM

Stock market report © CorbisBy David Sterman

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

The S&P 500 ($INX) has posted a very impressive rebound over the past 17 quarters. 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 a bull 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 on stocks and funds more likely to hold their own when the inevitable market correction comes.

"The line separating investment and speculation, 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 effortless money."

Warren Buffett made those comments back in 2000. Since then, he has repeated a simple notion: If you want to score solid gains, 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 this year'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. The VIX, 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 that profit 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, the VIX'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 Hedged Equity ETF (DXJ) at the end of 2012 (see StreetAuthority).

The fund has since risen a stunning 65%.

Trouble is, investors are still pouring money into this ETF. According to S&P Capital IQ, this fund has been the top asset 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 many emerging markets have risen only modestly. For instance, the iShares MSCI Emerging Markets Index (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 are bullish on the global economy, 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 (see StreetAuthority). It's a bit premature to spot a commodity rally just yet, but contrarian 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. With bond yields from blue-chip issuers such as IBM (IBM) and Coca-Cola (KO) offering yields below 3%, investors have instead been focusing squarely on the debt issued by less creditworthy corporations.

These kinds of bonds are called "junk" for a reason. They carry a higher risk of default, though we've seen few major bankruptcies 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 Yield Corporate Bond Index ETF (HYS) and the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). At some point in this economic cycle, these high-yield bonds will experience rising defaults, which could well lead to a furious exit from this riskier corner of the fixed-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.

David Sterman does not personally hold positions in any securities mentioned in this article.

More from StreetAuthority

May 17, 2013 11:57AM
There's another golden rule for stocks - buy the fear and sell the exuberance.

The S&P might be up 46% over the last 20 months, but it's only up 16% over the last 13+ years.  
May 17, 2013 12:40PM
You can't talk about the performance of the Markets over the last Decade and leave out the Importance of the explosion in Global National Debt. You can't talk about the performance relative to the last 13 plus years and omit the Massive Global Money Printing Scams.

How there is again record Buying on Margin. How about the Bogus explosion in electronic frequency trading. How about Global Feds buying stocks. WE all see how and or why the Markets continue to rise. We vary on how long it can or should last. People are buying on false perceptions, eventually they will be Selling on the Cold Hard Reality.

May 17, 2013 11:22AM
The golden rule on Wall Street id "screw everybody before they screw you".
May 17, 2013 12:11PM
I have read 10,000 blogs during this "Bullsh t Run" and very few times have I ever read something indicating intelligent investing. The Golden Rule of Psychopathy... if everybody's doing it, even if you know it's wrong, do it and beg for forgivemess or apologize after you get caught. Sorry, but pumping trillions into dead markets and converting formerly functional enterprises into business platforms was completely wrong. You won't get the chance to beg for forgiveness or apologize... once we are at war over the fundamentals of survival and sustainability.
May 17, 2013 1:40PM
Let the big boys eat it this time. This is nothing more than a sucker market for retail investors.
May 17, 2013 1:59PM
You should just have written the following: gamblers via "bend over Ben" Bernanke's lunacy are winning at the expense of savers/investors. Another FED led bubble. Which is exactly what they're suppose to be preventing via higher rates. This is so far fetched it's mind boggling as well as totally pathetic. 

The golden rule is this


The one with the Gold makes the rules.


That said we are all doomed they say stocks are ok to buy when they have P/E ratios of like 34


Back in the 1960's and 1980's the rule was if a company hit a P/E ratio of 5 buy it and sell it when it hit a P/E ratio more than 10.


Pretty the market is just plain over valued by a long shot.

May 17, 2013 3:34PM

So many bubbles everywhere. It's like I got up each morning for the last 180 days and drank an entire bottle of champagne for breakfast before going to work . Thanks Ben Bernanke for keeping me soooooo wasted.


May 17, 2013 4:58PM
When the music stops...you had better hope at least one other person is left standing...the market is an insiders game.
May 17, 2013 1:34PM

The only golden rule that matters anymore - Don' fight the Fed.

May 17, 2013 2:57PM
Some might not see it that way but The Global Feds are already fighting themselves. Everyone can't win. Soon or later, the Markets will figure this out. This a a Golden Era for Traders and a massive Trap for longer term Bulls.
May 17, 2013 4:56PM
Weekend homework... Andrew Dickson White: Fiat Money Inflation in France. Check out his timeline of historic events for the accelerated printing period. Read up on what happens when other things start to fall-off from the dilution. Good thing it's sumertime outside.
May 17, 2013 5:34PM

Buy low, sell high.


You heard it here first.


Or not.

May 17, 2013 1:10PM
What the writer doesn't realize is that his strategy is obsolete and has no relevance to the current market. Those who think they can outwit the commodities market are in for a little surprise. Those who think that emerging markets have greater potential are even bigger fools.
May 17, 2013 7:55PM
Just hope the market only have small correction instead  of it from crashing this time around. I have bad feeling when the government bought all those hollow bullets and try to take the guns away that the government knows something is coming and isn't Santa Claus. To light the fuse is for the market crash then dollar will follow it. What happened in 2008 will make it look like a grain of sand compare to the beach. Because we kick the can down the road and kept on printing money and fed's also kept buying our bonds to keep raising the market, we all have to pay the piper sooner or later. I hate to say it but I hope its much later because most of us are not ready for another round of 2008 X 10
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