Free 7-day Trial
All Articles and Columns »

Top 5 Things You Can Do When The Market Overheats

Larry Spears

The Dividend Guy Blog

10 followers
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

IS @ Intelligent Speculator

#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!


Rating: 2.1/5 (15 votes)

Comments

ansgarjohn
Ansgarjohn - 5 months ago
#6 In 1993, Buffett wanted to buy KO (Coca-Cola), but at a price that was about 10% below the market price. Rather than overpay, he sold put options at the price he wanted to pay and pocketed nearly $7.5 million in income while he waited for a price correction.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK
Hide