We’ve been running on the edge of a market all time high for a while now. From time to time, the good news is enough to push the limit a bit further. Technically, we could surge another 20% upwards before we hit a correction. Since we are currently trading around a P/E ratio of 17, there is still room to reach a multiplier of 20. Several market corrections have happened once we broke the mark of 20.
I’m sure you heard that the market is one week away from a crash from a friend or a colleague at work. They may be right, they may be wrong. This is not the important part. What truly matters is what you are doing with your own portfolio. After all, your coworkers won’t benefit from their “sound advice” through your portfolio and vice-versa. I don’t believe in selling my stocks when the market overheats while waiting for the next crash. This is why I have come up with to top 5 things you can do you with your portfolio when the market overheats. You can always forward this article to the folks around you who predicted a market crash; they might find it useful 😉
#1 Setup DRIPs
Once your portfolio is fully setup, one of the best strategies you can use is to increase your existing positions. The stocks you picked in the first place to be part of your portfolio should be good enough to receive more money. Instead of using your own cash, why don’t you use the dividend payout to increase your position?
The more dividends paid the more shares you hold and the more dividends will be paid later on. If the market ever goes down, your dividend will remain stable. Therefore, you will buy even more shares at a cheaper price. DRIPs create a kind of snowball for your investments. These snowballs will become big enough that you will eventually build a fortress!
On top of that, many companies give a discount bonus if you setup a drip with them. This is how you get the possibility to buy shares at a discounted price of 5% for example. Considering the discount + the future dividend payout on these new shares, you create a natural hedge against a market slump.
#2 Buy Defensive Stocks
If you are convinced that a market drop is coming but don’t want to sell all your investments to sit on pile of cash, some modifications to your portfolio can be done to improve it. Instead of hoping for high returns with “growth stocks”, you can sell those and aim for defensive stocks.
This is a basic principle of investing but we all know that growth stocks are hit the hardest during a recession while “value” stocks will show more resistance. This is also true about “cyclical” companies. For example, if I look at my own portfolio, I could sell Chevron (CVX) as its profit will go with the global economy. I could buy more Coca-Cola (KO) or look at a new investment into companies such as Colgate Palmolive (CL), Clorox (CLX), Procter & Gamble (PG), etc. I’m not saying these are good companies at a good price right now (that’s another story) but I’m saying that we will all continue to drink Coke, brush our teeth and clean our houses during a recession.
The good thing about defensive stocks is that they pay steady dividends. Instead of selling your investments and waiting in the money market at 1%, you can easily earn between 2.50% and 3% in dividends and your stock value will eventually come back to par once the storm is over. Defensive stocks offer a better return than money market funds at the moment!
#3 Pay Off Your Debts
The first two solutions were targeted to your existing investments. What happens if you have new money to invest? Should you buy even though the market is overheating?? This is a pretty good question, isn’t it?
Instead of adding more cash to your investment account, a smart thing to do could be to pay off your debts. If you are paying anything over 4% on any debt, a smart move is to pay those off. Think about it: paying 5% on debt is the equivalent of making a 5% investment return (and probably more if your investment account is taxable!).
It is true that you lose the advantage of compounding interest (which doesn’t exist on debt). However, an expensive market only lasts for so long. If you give yourself one or two years to pay off your debts, the market will probably have crashed by then and it will be the time to invest again.
Then, you will have two very interesting options:
#1 Use any further new money to invest in a cheap market
#2 Leverage from the previously paid debt and invest massively in a cheap market
This will be up to your risk tolerance, but it could be something very interesting as an investment strategy.
#4 Market Neutral Strategy?
Over time, some trading geniuses invented investing strategies that will ride the market wave regardless of if it’s going up or down. One of these strategies is called “market neutral”.
The idea is relatively simple: you take a bet that one company will go up while another will go down. You short sell the “losing company” to buy the “winning company”. If you are right, you make money regardless if the market goes up or down. This is why it is called “market neutral”.
While the idea is pretty simple, making money off this strategy isn’t. Imagine if you are wrong on both companies? Imagine someone who would have taken the bet that RIM (BBRY) would beat Apple (AAPL) in the smart phone industry? This trade would have been catastrophic for one’s portfolio!
If you take the bet the market is going down, short selling cyclical stocks to buy defensive stocks could be an interesting strategy. If you want to read more about market neutral strategy, I know two bloggers who do such trades:
Martin @ Hello Suckers
#5 Stack Your Cash and Be Bored
Yah… the last thing to do (and I mean it) when you think the market is heading sideways is to sell your investments, stack your cash… and be bored! When you think about it, not much good can come out of this strategy. If you are right and the market goes down, you will spend hours figuring when is the right entry point. If you are wrong and the market goes up for another 12-18months, you will be stuck earning that mediocre 1% from the money market fund.
If you ever go back in after 6 or 12 months, you expose yourself to bigger risk of losses without any benefits. Plus, you don’t get paid to wait by cashing your dividend payouts. Seriously, why you would bet against the house? You know it always win, right?
Final Thoughts on the Market
To be honest, I’m still optimistic about the stock market. I’m not as excited about investment opportunities as I was 2 years ago, but I still think there is some room to move upward. The Canadian market is still a bit worrisome right now due to the housing market and, there continue to be be some good opportunities at the moment.
In the end, if companies keep posting higher profits and sales, the stock market will continue to climb and the P/E ratio will remain the same. The key is to carefully follow your stocks and look at trends for each of them. Only time will tell!
This is why I’m working on this special dividend project right now. I’m currently developing an investing tool that will help investors manage their portfolio during volatile times like this one.
When should you buy? When should you sell? How can you start investing with $1,000 in your pocket? What should you do with your next $10,000?
These are all questions I answer with this special dividend project. If you want to know more about it,sign-up here and you’ll get in the know before anybody else!
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I agree with you that I don’t think the market is really due for a correction. People that think the market is too high are looking merely at prices without taking into consideration valuations. If companies earnings justify the higher price (which they will over time that is why the market will always reach new highs) then there is no reason to expect a crash. Only when market levels become irrational because investors push prices up higher than earnings justify should be begin to worry about a big correction or crash. Until then I’ll just keep on keeping on with the plan. Continuing to purchase high quality, reasonably valued dividend growth stocks and collecting my dividend checks!
Seems like we still have a few years left, but who knows. What about just ignoring it and keep buying when you have extra cash?
My own perspective on this.
I used to drip a few stocks but got fed up with having just small amounts of cash to diversify in ot other sectors. So if your dividends ar significant then you should consider the payout as an opportunity to diversify. If dividends are smaller then dripping is probably the way to go
#2 – Defensive stocks. Always good to have toothpaste and bandaid companies. Just pay attention to the price. You know, Buy Low – Sell High. I own JNJ, a good defensive stock, but still looking at the upside potential from where it sits right now.
#3 – Pay off the debts. If you are investing, in theory you should not have any personal debts except for your current credot card balance. Can’t pay it off every month? You shouldn’t be investing – you can not afford to take the chance.
There is still “good” debt. If you can write off the interest charges against investments that pay dividends then go ahead. Just keep an eye on the income versus the interest. Your income (dividends) should be able to pay the service charge as well as pay down the principal over the year. It is “free” income in that you only pay tax (at your rate)on the difference between the service charge (interst) and the total payout. Jus tremember that stocks do go down as well as up so you have to be able to sleep at night. Keep an eye on the interest rates as well. Any increase (it will happen some time) and you should re-evaluate your position.
#4 – Market Neutral. Sounds like you are betting against yourself. Don’t think much of it. I like to buy & hold but do sell especially on volatile stocks that have mood swings. Hopefully selling above purchase. Not much use to losing money.
#5 – Stack Your Cash. Well it depends (among other things) on where you are in your life. I am approaching retirement so cash is starting to look good just in case the market slides. And if it does then you can evaluate if you want to jump in and buy or build the cash for the mandatory withdrawals when you convert to a RIF.
I have just about always been fully invested in stocks unless I jsut sold something and have not found something I like. But cash does not pay you very much on it’s own.
I am at the point where I try to concentrate the cash to make a worthwhile (enough stock) purchase to easily offset the in and out costs. Purchasing ten stocks of a company just does not seem worthwhile to me. If it takes 5 months of dividends just to pay those fees then I will accumulate cash until it is worhtwhile, usually every three months (quarterly dividends).
Where is the market now? Things that go up WILL come down sooner or later. Mining stocks are in the pits now. Just might be time to have a good look at the big boys. Iron ore was all th erage three years ago. Not now and it has dragged down a lot of other stocks as well.
My opinions for tonight.
Appreciate the article.
I prefer No. 3: “#3 Pay Off Your Debts”
If you have a debt interest rate of 6,5% for your house, I think it´s always better to pay off the debts instead to buy shares!
In Germany pay off the debts is of coures tax free.
But the Dividend income is not tax free!
Now I have a debt-free home since April and I can concentrate on Dividend Growth Investing now!
regards!
Dividenden-Sammler
Hey Dan & Joe,
Keep buying, this is what I do :-). But we can’t go against people who think the market is going to crash right? There are many options besides selling your stocks and wait!
Hello Ricardo,
Thx for your thoughts. I think one can invest in its retirement plan even if he has debts. For example, I do have debts (I’m in my early 30’s, 3 kids and a wife!) but I’m actively building my retirement nest egg at the same time I am paying off my debts. However, I could use my next investment contribution to pay off more debts if I thought the market would crash anytime soon.
Cheers,
How about selling put options? If you feel a major crash is imminent that’s probably a bad idea, but if you feel the market is largely at fair/high valuations for the near future, rather than sitting on growing cash you could sell put options that will probably expire but at least give you some gains without paying more than you want to.
Hello Erich,
You have to be right as selling puts could also turn into some major losses if the market continues to go up!
Hi Mike,
Thanks for listing me in the article 🙂 The link doesn’t work however.
As far as the trades I haven’t used that strategy. I used similar to it but not using stocks, but options (straddles), but not anymore. But that strategy works that you typically speculate to both directions and if the stock moves one way, you close the opposite trade and let the winning one run. Too much work and risk for may lazy nature, so since the end of 2012 I stick to dividend investing and basic option strategies only.