How to prepare now for a stock-market 'melt-up'

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  • By Mark Hulbert,
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You'd think that investors would run for the exits if they thought the stock market was forming a bubble. But you'd be wrong.

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In recent weeks, many of the advisers I monitor have given up trying to justify the stock market's current valuation. With the S&P 500 (.SPX) up over 20% over the last 12 months, these advisers now freely concede that the stock market appears to be in a bubble. Yet, in almost the same breath, they advise clients that there's no need to sell just yet.

Have they lost their minds? That's always possible. But the more I examined the issue, the more I discovered a different possibility: It's not necessarily irrational to continue investing in the market even as the odds of a bubble increase — even if it's not for the faint of heart.

I owe this insight to James Montier, a member of the asset allocation team at Boston-based GMO. In a study he conducted several years ago, he pointed out that investing in a bubble can be rational so long as the market delivers ever-higher returns as the odds of its bursting also increase. It's just a matter of risk and reward: If the reward is great enough, virtually any risk can be tolerated.

Though Montier doesn't use this analogy, it's akin to playing Russian Roulette with your money. Each successive month in which the bubble doesn't burst is akin to the gun firing a blank. Of course, that only increases the odds even more that the bursting will happen in the subsequent one. To continue playing the game, investors need to be promised a bigger and bigger payoff.

Montier's model helps to explain why the market's advance becomes parabolic right before a bubble bursts. Just recall the market's rise in the final stages of the internet bubble: In the last six months before that bubble burst in March 2000, the Nasdaq Composite (.IXIC) doubled in value.

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This is also part of the reason why Montier's colleague, Jeremy Grantham, is advising clients to ready for themselves for a "melt-up" in the stock market before the current bubble bursts. He points out that, strong as the stock market has been over the last year, it hasn't risen at the near-parabolic rates that were produced in the latter stages of past bubbles.

How do you invest in such an environment? Grantham, who is a value investor, recommends that we allocate the bulk of our equity portfolios to the most undervalued (least overvalued) stocks, primarily those in emerging stock markets and some of the more developed non-U.S. economies. To participate in a possible meltup in the U.S. market, he recommends investing a smallish amount in those U.S. stocks exhibiting the greatest momentum.

His rationale: Historically, as the market approaches the top of a bubble, the advance is powered by fewer and fewer stocks. A focus on the best-performing stocks therefore is most likely to keep you participating in the final stages of the bubble.

Of course, at some point the bubble will burst. And, by definition, not everyone can be the first to leave the party.

For those who value their sleep, and I assume that's most of you, you should be preparing to leave the party in coming days — if you haven't already.

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