Is This A Bubble? Can I Keep Emotion Out of My Plan?

It goes without saying that domestic stock markets have been strong this year. While the S&P 500 is up over 26% year to date in price as of Friday’s close (11/15/13), it has yet to suffer a correction of even 10%. The largest drawdown so far this year was only about 7.5%. This is a strong departure from the last few years where daily volatility was quite elevated by historical standards, and peak-to-trough declines routinely measured in the double digits.

Small, large and middle sized stocks have been strong in 2013. Most investors with U.S. stock exposure have likely enjoyed decent returns this year. A good number of investors have probably not outperformed U.S. stock benchmarks since they hold diversified portfolios that include international stocks and bonds-both of which have lagged U.S. stocks. Nonetheless, diversified portfolios have seen decent gains on the year.

Years like this tend to cause many investors-especially those who got overly conservative when they were scared a few years ago-to shift their mentality from “I just don’t want to lose money” to “The market is running away from me, and I need to do something to keep up.” This mentality shift can cause a self-fulfilling cycle where people begin and continue to chase returns by pursuing more and more risk as markets continue to rise. This pursuit, in part, causes more market advances.

Sometimes this pursuit of returns ends in bubbles and busts, much like in the late 1990s where actual earnings and business sustainability were afterthoughts and the only thing that mattered was, “It’s going up.” Sometimes, markets simply pause for a bit, shake out the speculators and resume their upward path.

It’s hard for us to argue that there is a bubble in stocks, with most valuation metrics trading near their historical averages. We’re a bit surprised by the magnitude of the gains in 2013, but we don’t see bubbles. With low inflation and stable, yet slow, economic growth and a lot of monetary accommodation, we think markets can continue to offer investors fair returns.

At the same time, we have to reiterate a message we’ve touched on a few times this year. Please don’t get so excited that you change your plans based on emotions. We have warned against getting too bearish in 2009 near the market bottom and in 2010 and 2011 during the heights of the Euro crisis. Investors who “knew more than the market” were hurt if they sold at those times.

Fear and greed don’t usually pay off in investing. Crafting a comprehensive plan that focuses on a reasonable asset allocation for your goals, spending and savings strategies and an eye toward your goals instead of the market usually works better. It’s been a good year so far. Enjoy it, but remember, don’t get too excited.





Edited remarks of Kane S. Cotton, Bellatore – CFA, VP & Chief Investment Strategist