MarksJarvis: Bracing for a potential stock market plunge

Some analysts say a steep downturn is around the corner

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Stock Market

A trader works on the floor of the New York Stock Exchange at the closing bell on Nov. 18. U.S. stocks closed at new records after the Dow topped 16,000 for the first time and the S&P 500 breached the 1,800 mark. (Getty Images / November 18, 2013)

For those savoring these sweet moments of stock market bliss, brace yourselves.

Wet blankets are starting to fly — with skeptics of the stock market insisting that the joy of 26 percent gains in the Standard & Poor's 500 can't last. They say stocks have become too pricey and markets don't climb forever, especially after soaring more than 160 percent over about four years.

But if their warnings get your attention, and you join the crew trying to spot dangers for your 401(k) or individual retirement account, your vigilance might become an aggravation.

The stock market skeptics are on the lookout for a "correction" of perhaps a 10 percent drop in the market. But knowing when the damage will arrive is anything but an exact science.

Just look at the end of the 1990s. It was 1998 when the public's infatuation with stocks pushed the largest 50 stocks to insane prices that seemed destined to end in ruin.

The prices of those 50 stocks averaged 45 times the earnings those companies were expected to generate, said Douglas Ramsey, the Leuthold Group's chief investment officer. In other words, the P/E — or price-earnings ratio — was 45. Even if you can't do the computation, the message seemed clear. Stocks don't usually get anywhere near that pricey. The average P/E based on history is about 15. So 45 screamed "impending disaster."

Yet, even with the evidence unmistakable in 1998, investors ignored it and the market climbed for two more years before plunging 49 percent. So even though analysts are waving red flags about pricey stocks now, that doesn't mean pain is imminent. The P/E for the Standard & Poor's 500 is 16.9.

"Valuations are not good predictors" of when stock market plunges will come, Ramsey said. And while he thinks both large and small stocks are overvalued now, "and not appealing," he thinks large stocks, in particular, will keep climbing for several months.

The bull market, or the rise in stocks that began in early 2009, probably has about 12 months of life left in it before a sharp decline, he said. Typically, when bull markets start to age, analysts observe what's called a "topping process," with multiple types of stocks consecutively dropping from their peak prices. Ramsey says that seems to have started with utility stocks and REITs (real estate investment trusts) last spring. Utility stocks have declined about 4 percent in the past six months, and the Dow Jones REIT index has lost about 12 percent.

Yet, on Friday there was widespread strength in the market across most sectors. Stocks that depend on growth in the economy, and in particular transports such as railroads and airlines, have been on a tear — climbing about 45 percent, Ramsey said.

Both small and large company stocks hit records Friday, although Ramsey says small-company stocks are particularly vulnerable. The Standard & Poor's 600 index of small company stocks had climbed an extraordinary 34 percent this year, while the large stocks of the Standard & Poor's 500 are up a lot too at 25 percent — but skimpy by comparison.

Tim Hayes, strategist for Ned Davis Research, anticipates a correction of about 20 percent around mid-2014. Early in the year, he thinks stocks will continue to climb based on a strengthening economy, but by the second quarter, excessive optimism, including "elevated earning expectations," will leave "the markets vulnerable to inevitable disappointments."

The decline should involve markets worldwide, Hayes said, but because he isn't expecting a global recession, the "downside damage" should be limited. The severity may depend on how far investors are carried away with their profit expectations for the new year. Ramsey says expectations are ambitious.

Thomas Lee, of JPMorgan Chase, says the biggest risk to the market would be a shock set off by the Federal Reserve. Investors think the Federal Reserve will continue to pump money into the economy through its quantitative easing process. But if the Fed cuts that off abruptly, with the economy still weak, nervous investors would likely dump stocks on the expectation that the economy and companies won't thrive without the Fed's continued tinkering.

Still, Lee said, even with the recognition of that risk "we would remain slow buyers of equities into year-end." And Ramsey, while cutting back exposure to small company stocks, still has 60 percent of his core fund invested in stocks.

Likewise, Jack Ablin, chief investment officer of BMO Private Bank, says he has had clients reduce holdings of U.S. small company stocks and add less-pricey European, Japanese and emerging market stocks. But for a client who needs income and will accept moderate risk, he continues to keep 70 percent of the portfolio in stocks.

"Even a 10 percent correction is not something to time and run from," he said.

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis

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