What goes up must come down

Ten years have passed since Lehman Brothers collapsed, precipitating the global financial crisis that swept Wall Street and sparked a recession. Once the markets recovered from the shock, stocks began creeping back up and were recently trading at record levels.

Lately, though, the markets have become more volatile, and some experts have begun to worry about the possibility of a prolonged slump. Does that mean it’s time to sell some holdings and realize profits? And if so, where should you put that cash?

First, understand that any sell-off in stocks may be short-lived. Analysts point to a range of data to show that the economy is strong. “Corporate earnings are so powerful, and the [government’s spending on] fiscal stimulus has created so much momentum, that the economy…is showing a lot of broad-based health,” says Michael Tiedemann of Tiedemann Advisors.

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While newspaper headlines can look scary, it’s important to make a distinction between events that can impact the price of stocks temporarily and those that pose risks to companies’ fundamentals, which can hurt valuations for the long term, says Scott Clemons, chief investment strategist for private wealth management at Brown Brothers Harriman. And just because a market has been rising for a long time does not necessarily mean it’s due for a crash.

“Bull markets don’t die of old age,” says Kate Warne, an investment strategist at brokerage house Edward Jones. What kills them are rapidly increasing interest rates, among other economic death knells. Because the Fed is raising rates slowly, a market crash appears unlikely in the short term, she believes. Clemons agrees, noting that while the world seems to be heading for trouble, with the prospect of a trade war with China, turmoil in emerging markets, and Brexit, those issues won’t have a major impact on corporate profits. At the same time, the U.S. is seeing strong job growth, increasing wages, higher profits, and rising economic activity overall. “Those are all related: more money in people’s pockets is good for consumer sentiment and good for the market,” he says.

What will eventually lead to a bear market, Clemons believes, is “some kind of crash in one of those things.”

What’s certain is that a falling market will arrive sooner or later and that when it does, those who have let their portfolios become overly weighted with stocks will lose the most. “We suggest the first action people take right now—because stocks have risen so much in relation to bonds—is sell some stocks and add bonds to get back to the mix of equities and fixed income that fits your long-term objectives,” Warne says.

If you started off the bull market with 65 percent stocks and 35 percent bonds, and your stocks rose in sync with the overall market, you could have more than 80 percent of your portfolio in stocks now, Warne notes. It’s nearly impossible to time the market, so you and your financial adviser should decide what percentage of your portfolio should be in stocks, bonds, real estate, and cash—and stick with your allocation no matter what the market does.

“It goes against human instinct to sell something that’s rising in price to rebalance, but rebalancing is an important part of an investment approach, which is borne out in academic literature and my own experience as an investment adviser,” Clemons says. If you anticipate needing cash soon for a major purchase like a home or college tuition, you may want to leave that money on the sidelines so you won’t have to sell if a bear market coincides with your real estate closing or your child’s high school graduation. You should also think about how comfortable you will be if your investments lose value. If you’d have trouble handling a down market psychologically, bail out now.

Ask yourself, “What will you do when stocks drop 20 percent?” Warne suggests.

Once you’ve sold your excess stock investments and portioned off any cash you think you’ll need soon, you’ll have to reinvest the remaining dollars.

Start with rebuilding your bonds, either with individual issues or with bond funds. If you assemble a bond ladder with a waterfall of maturity dates, you’ll have cash flow that saves you from having to sell stocks if the equities market falls.

“While bonds haven’t performed as well as stocks, they’re still attractive,” Warne says, in particular short- and medium-term bonds.

When buying bonds now, Clemons advises, focus on short maturity and high quality to avoid the risks of inflation. The bond portion of your portfolio is there for stability, not as a generator of income, he says.

You may also want to rejigger your stock holdings, taking money off the table if you’ve earned profits and putting it back into stocks trading at bargain prices. What’s cheap now—or, at least, not too expensive—is energy infrastructure, such as natural gas pipeline stocks, Tiedemann says. Now recovered from a low point in 2015 when the energy market punished infrastructure stocks, these companies have earnings that are growing 6 to 7 percent annually, he notes.

U.S. companies with market capitalizations between $5 billion and $10 billion are also a buy, Tiedemann says. He anticipates that many of these companies will acquire or be acquired by rivals, and will bring home overseas cash in the wake of last year’s federal tax changes.

“Mid-cap domestic equities received the benefit of all the organic economic activity and the repatriation of capital and will likely be the beneficiaries of M&A activity,” he says.

Warne also likes small and mid-cap U.S. stocks now, because they are likely to benefit more than larger companies will from the tax cuts, and they are mainly insulated from rising tariffs.

Overseas, Warne prefers large-cap companies in developed markets, like Europe. Those are attractive because the strong dollar has made their shares less expensive for U.S. investors.

Clemons recommends seeking out “boring parts of the market,” such as consumer staple manufacturers that pay decent dividend yields of around 3 percent. For instance, in an economic downturn, consumers won’t cut their purchases of Listerine, Visine, or Tylenol, so the maker of these brands, Johnson & Johnson, is a safe bet, he says.

Another area that investors should examine is emerging markets. While Venezuela, Turkey, and Argentina are each experiencing a crisis right now, many other developing countries—most notably India and China—are ripe for investment, Clemons says.

“The contrarian idea that we put into client portfolios is that if you’re a long-term, patient investor, emerging markets are really interesting right now,” Clemons says.

At this point in the market’s rise, he adds, his firm is advising clients to stay away from tech giants like Facebook, Google, and Netflix, because those stocks are relatively expensive.