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Seven ways to prepare for a coming correction

Sir John Templeton once told me, "The world belongs to the long-term optimist, as markets go up two-thirds of the time, and humans tend to always figure out the problems of the day. To be anything other than a long-term optimist flies in the face of historical fact."

While I believe Sir John was right, I feel compelled to share what is seriously worrying me. I sense that we are approaching a challenging inflection point.

I find myself dreading what might be ahead, particularly in the U.S. markets and some sectors of the Canadian markets. As a deep value investor with a contrarian ethos, I don't understand the current level of bullishness and complacency. The valuation metrics of certain markets are flashing major warning signals. Even though we have made some nice gains, we simply had to take some profits recently as we can't justify staying fully invested today.

I am not saying that there are no investment opportunities currently available, it's just that you have to dig a lot deeper to find them.

It's amazing to see how we can go from the extreme lows of March 2009 to where we are today, with the S&P 500 up almost triple (196 per cent) in 5.33 years. Now, sentiment is bullish and complacent, while stock market valuations are on "the high side of fair", as Howard Marks, the founder of Oaktree told me at the TIGER 21 Global Conference five months ago. Since then, markets have climbed even higher.

We were aggressive buyers of equities in early 2009, as we saw excellent valuations. It was nerve-wracking to buy things when there was so much fear after markets had fallen more than 55 per cent from their highs in 2007/2008. Now, we are nervous for the opposite reasons.

The three charts below illustrate my concern.


1. What happened the last four times U.S. stocks rallied for 23 quarters? Does the chart above look sustainable to you? The S&P 500 has climbed almost 200 per cent and is in its 23rd quarter of its recovery. As you can see, the last four instances of similar magnitude ended very badly.

Source: Standard & Poor's

2. The above chart shows that S&P 500 earnings (inflation adjusted) have just hit an all-time high. Things are not likely to get much better than this "Goldilocks" scenario.

Source: JPMorgan Asset Management

3. The illustration above depicts annual returns and intra-year declines over the last 34 years up until first-quarter 2014. This one is an excellent reminder that market corrections occur very regularly, on a historical basis.

What I find most disturbing is how muted volatility has become over the last few years, and how the U.S. market has basically gone straight up with only a few shallow corrections. The quantitative easing policies of the world's central banks have been the main reason for this.

How to prepare for what's coming
Investors who share my concern may want to consider the following "de-risking" portfolio tactics:

1. Raise 5- to 15-per cent cash, depending on your investor risk profile, by trimming some "winners" now.

2. Consider adding to USD after CAD's recent short-term strength to 94 cents.

3. Increase "alternatives" such as market neutral, global, long/short and long/short credit.

4. Chip away at some multi-strategy emerging markets portfolios/ETFs as they are still very cheap.

5. If you have already missed out on the 2014 bond market rally, raise even more cash instead.

6. Ensure you have developed a "watch list" of securities/managers/ETFs that you would consider buying 10-to 20-per cent lower.

7. Prepare yourself mentally to be a strong buyer of your watch list when the market's mood turns ugly again. History has proven it will.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as Portfolio Manager and Director, Wealth Management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. ( The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

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