about 3 years ago • 4 mins
It’s getting increasingly difficult to ignore signs that investor optimism is getting a little out of hand. In my experience, it’s at precisely those moments when everyone thinks stocks can only keep going up that things are most ripe for a market pullback. Happily, however, there are steps you can take to protect yourself ahead of that happening.
After a year in which US stocks climbed despite the country experiencing its sharpest economic contraction on record – and 13 years on from the last significant annual drop in the S&P 500 index – it’s perhaps understandable that investors appear to have forgotten that the only way ain’t up.
That’s especially true of retail investors. According to data platform Quiver Quantitative, the most popular stocks among individuals have done even better than the wider market recently. Quiver’s “WallStreetBets” portfolio, which tracks the performance of the five most-mentioned stocks on the eponymous Reddit forum in any given week, is up 62% over the past year – trouncing the S&P 500’s 15% gain.
In a market where gains seem so easy to come by, there are a growing number of increasingly worrying signs that some investors are getting carried away.
Exhibit A is research firm Bespoke Investment Group’s list of “ludicrous” US-listed companies that have a price-to-sales ratio greater than 10 and a share price that’s at least doubled over just the past three months.
Companies have to be worth at least $500 million to make the cut, in order to exclude any misleading minnows. Even then, however, the count of “ludicrous” stocks currently stands at 59 – representing a significant recent rise, albeit still some way short of the 120-plus firms that made the list at the height of the dotcom bubble in 2000.
And then there’s investors’ growing interest in the smallest (and therefore riskiest) shares. One day last week, trading in these “penny stocks” (think The Wolf of Wall Street) accounted for almost a fifth of the total volume of shares changing hands on US markets. This is not normal.
An associated trend is the rise of cult stocks like Tesla or Plug Power. Shares in such firms, which typically operate in fast-growing markets like electric vehicles or meat alternatives, appear more sensitive to changes in sentiment than in boring old fundamentals like revenue or profit. Just look at how NIO, a Chinese maker of electric cars, has seen its stock price shift in tandem with social media mentions.
The huge boom in initial public offerings (IPOs) is also ominous. Private companies naturally flock to the stock market when public investors are willing to pay higher prices – which means IPO peaks almost always coincide with market tops. 2020 was the biggest year for IPOs globally since 2007, right before the last major financial crisis, and 2021 may end up even more riotous.
Finally, it’s hard not to see the recent resurgence in bitcoin – perhaps the ultimate “cult” investment – as another indication of investor ebullience, at least in part. Especially when more than a million people follow an astrologer on TikTok for crypto trading tips…
All this points to investor caution going out the window – classically a surefire sign of an imminent market peak. So should you abandon stocks altogether? Probably not. Precisely timing tops and bottoms is notoriously hard: former US Federal Reserve chairman Alan Greenspan’s famous “irrational exuberance” speech in December 1996 was followed by three more years of stock price gains before the dotcom bubble finally burst.
Stocks could well have further to climb this time around too, despite the perilous portents. And there are, admittedly, few other enticing places to put your savings right now. The stock market looks expensive, but bonds are even pricier.
Still, if you think the time is right to take a little risk off the table, you could start by shifting your portfolio more towards safer “defensive” stocks. Shares of consumer staples companies, which sell essentials like food and cleaning products, are currently their cheapest in more than 12 years compared to the wider market. They could end up proving prescient bargains when the penny – and the S&P 500 – finally drops.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.