How to invest during a stock market bubble

With the stock market hitting record highs, some investors may be worried that equities could soon face a crash.

  • By Debbie Carlson,
  • U.S. News & World Report
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With the stock market hitting record highs, some investors may be worried that equities could soon face a crash.

"There are certainly many signs the stock market could be getting out over its skis and a correction may be looming," says Jim Paulsen, chief investment strategist of The Leuthold Group.

He points to several factors driving that thinking, including the Russell 2000 small-cap index (.RUT) more than doubling from its lows last year, extremely high valuations compared to historic norms, significant fiscal and monetary stimulus in reaction to the pandemic, price surges in heavily shorted stocks, and cryptocurrency prices being more volatile than usual, among several other events.

Now some investors might be wondering if a market bubble is forming – or ready to pop. Market corrections are inevitable, but a popping bubble can wreak serious financial damage along the lines of the 2000 dot-com bubble bursting and the 2008 financial crisis.

Predicting market downdrafts is nearly impossible, and long-term investors are best served staying in the market. Yet riding out those breaks is tough, even for seasoned professionals. "I'm a risk-averse type of investor myself. I don't have the stomach for 20% to 30% drawdowns; I just can't do it," says Jon Burckett-St. Laurent, senior portfolio manager at Exencial Wealth Advisors.

There's no magic bullet position that allows investors to stay in the markets and never lose money, but investors can minimize their losses. To do so, investment professionals offer five strategies:

  • Buy an equal-weight fund.
  • Develop a barbell portfolio.
  • Buy dividend-growing stocks.
  • Use options-based strategies.
  • Take some profits.

Buy an equal-weight fund

Stock markets such as the S&P 500 (.SPX) are market-cap weighted, so big companies like Apple (AAPL) have a greater influence on price than smaller companies. Another way to rank companies is in equal measure, meaning every constituent has the same weighting, regardless of size. Exchange-traded funds such as the Invesco S&P 500 Equal Weight ETF (RSP) measure the performance of the S&P 500's companies in equal weights.

Sam Stovall, chief investment strategist at CFRA Research, says during the tech bubble of 2000-2002, the S&P 500 equal weight lost less than half of the market-cap weighted index. While equal-weight investors still lost money at that time, it was significantly less than what a market-cap weighted investor experienced.

Stovall says investors who are concerned that the market is being narrowly led higher by growth and tech stocks could consider an equal-weight investment if they worry that a fall in these stocks could cause a sharp correction similar to 2000-2002.

Develop a barbell portfolio

Investors who buy individual stocks can use what Stovall calls a "barbell portfolio," owning both last year's winners and losers. This is a strategy he likes to use at the beginning of the year. Owning last year's performance leaders is akin to letting winning stocks ride and buying last year's losers is similar to buying low to hopefully sell high. The barbell portfolio contains 10 stocks or subindustries each of both the winners and losers, for 20 holdings total.

Stovall says, historically, by owning both, this portfolio strategy has outperformed the broader market on both a percentage basis and a frequency basis, meaning the frequency of advances is positive. He says in 2000, the barbell portfolio was up 1.5% versus the S&P 500's loss of 10%; in 2001, the barbell strategy fell 4% and the broader market declined 13%; and in 2002, the barbell portfolio lost 19% while the S&P 500 fell 23.4%.

For a 2021 barbell portfolio, a few of the best performing subindustries of 2020 included agricultural and farm equipment, air freight and semiconductors. The worst-performing subindustries in 2020 included airlines, utilities and travel.

Buy dividend-growing stocks

Look for companies that have a good track record of raising dividends, Stovall says. These companies are known as dividend aristocrats – S&P 500 companies that have paid and increased their base dividends annually for at least 25 straight years.

Stovall says dividend aristocrats that offer a yield of more than 2.5% and come with a strong buy recommendation by CFRA analysts include General Dynamics Corp. (GD), Genuine Parts Co. (GPC) and Cardinal Health (CAH).

"This is an idea to where you can buy a handful of stocks and sort of set it and forget it," he says. "Hopefully, they'll continue to pay or increase their dividends in the future the way they have in the last straight 25 years."

A few ETFs incorporate this strategy, although not all of them follow the 25-year rule. Some of these dividend-payer ETFs include the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), the ProShares S&P Technology Dividend Aristocrats ETF (TDV) and the SPDR S&P Dividend ETF (SDY).

Use options-based strategies

Burckett-St. Laurent suggests a few simple defensive options strategies. Stock options give investors the right, but not the obligation, to buy or sell a security at a given price.

Investors who are worried about another market downdraft, such as what occurred in February and March 2020, can buy puts, which gives the buyer the right to sell a security at a certain strike price on or before the expiration date. Buying puts is like insurance, he says, since it has an expiration date. "If you're worried the market will pull back in the short term, you can buy a put, which will protect you."

For example, if the SPDR S&P 500 ETF Trust (SPY) is trading around $370, an investor who thinks prices will fall can buy a put option trading at the $360 strike price. If the option costs $10 and the ETF falls to less than $350, the put will increase in value because the underlying ETF price is falling. If the ETF price rises, the put expires worthless.

Take some profits

Mike Zigmont, head of trading and research at Harvest Volatility Management, says nervous investors can sell some of their holdings. "If something in your gut feels uncomfortable, the best thing you can do is just sell a little bit," he says.

That said, don't exit the market completely. "All or none decisions are just recipes for disaster," he says. "Take a little bit of action if something is making you feel nervous."

If stocks make investors nervous, he says to sell perhaps 5% or 10% of a position and put it in something with short-term safety, such as a U.S. Treasury bill or a municipal bond fund. And ignore the naysayers. "Respect that feeling, and don't let anyone tell you that you shouldn't feel the way you feel," he says.

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