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4 Critical Observations as Stock Market Churns Higher

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Whether markets end up higher or lower is anyone's guess, but here are some things worth noting right now.

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It has been a phenomenal year for stocks, and the market continues to churn higher nearly every day. It seems as though the market has a propensity to overcome nearly every crisis that the media can throw at it while reliably grasping at new highs on a regular basis. As a money manager, I am enthusiastic about the outperformance of US stocks and relishing the consistent steady returns. However, as a risk manager I am careful to not get overly exuberant and remember that the rug may be swiftly pulled out from under us when we least expect it.

The recent report that the Vanguard Total Stock Market Fund (MUTF:VTSMX) has surpassed the PIMCO Total Return Fund (MUTF:PTTRX) as the largest mutual fund in the world is a testament to the increasing appetite for risk among retail investors. Bonds are now looked at as an increasingly dangerous asset in the face of a growing anxiety that the Federal Reserve will soon begin tapering its asset-purchasing agenda. The threat of rising interest rates has capped gains in bond funds this year and sent investors fleeing to the relative "safety" of equities.

Just as bond funds became overly loved in the first half of this year and interest rates fell to unprecedented lows, I fear that the same scenario will eventually unfold for US stocks. There is some level of credibility for the "Great Rotation" out of bonds and into stocks as the Fed eases itself away from the table. However, if you think that money coming out of bonds is going to create a consistent bid in stocks for the foreseeable future, then you might be in for a rough ride.

We are eventually going to hit a bumpy patch that will see US stocks reverse their trend higher and send investors fleeing for the safety of cash or fixed-income securities. This is simply a function of the regular ebb and flow of the market that has created wealth for generations. The key to prospering is preserving your wealth when the tides change.

Right now we are seeing small rotations in index leadership which may be a sign of institutional investors starting to jockey for position before the end of the year. What I think we will see through the remaining two months of 2013 is a push/pull between the latecomers who are chasing performance and the early adopters who are looking to lock in gains on their positions. Every portfolio manager dreams of years when they can lock in 20%+ returns.

Whether we end up higher or lower from here is anyone's guess, but the following are some observations that are worth noting:
  • The iShares Russell 2000 ETF (NYSEARCA:IWM) has been the clear leader all year but faltered last week as the rest of the market remained relatively strong. This will give some life to the bears as momentum shifts of this nature can often be a warning sign of risk aversion.
  • The SPDR S&P 500 ETF (NYSEARCA:SPY) and PowerShares QQQ (NASDAQ:QQQ) have continued to push to new highs and remain in healthy uptrends. These power indices continue to churn out positive gains on an almost daily basis to push their total return to 26% and 28% respectively this year. My advice is to trail your stop losses higher so that you can lock in gains if we get an unexpected reversal.
  • Commodities have been horrendous this year and continue their long-term descent. The broad-based PowerShares DB Commodity Index Tracking Fund (NYSEARCA:DBC) is near its 2013 lows and does not appear to be showing signs of a turnaround just yet. I am avoiding this space until we see a return of demand for soft commodities and precious metals. I would rather wait for a new trend to develop than try to catch a falling knife.
  • Bonds have risen from the dead and appear to be catching a bid. The consensus seems to be that the Fed's taper decision has been put off until 2014 which has opened the door for asset flows back into fixed income. High yield has been strong all year and we are now seeing a rebound in core intermediate-term holdings such as the PIMCO Total Return Fund (NYSEARCA:BOND) and the iShares MBS ETF (NYSEARCA:MBB). This could be a sign that investors are looking to hedge their highly appreciated stock positions or taking advantage of higher yields on these ETFs.

My advice on trading the remainder of the year is to continue to ride the trend while it lasts with the commitment of trailing stop losses to lock in gains. I am not actively adding new equity holdings to my portfolio at this level, but I am continuing to note changes in sector leadership and adjust my watch list accordingly for the next buying opportunity. I will be using any weakness to add to core holdings and rotate into areas of the market that I feel have the best potential for growth in 2014.

I am using that same strategy with respect to income-producing assets as well. High yield is rich right now, but there are still other areas of the market that are offering value in actively managed closed-end funds, preferred stocks, and even select real estate funds.

No matter how you trade the final months of the year, be careful of becoming entrenched in a single bias toward one asset class. Broaden your horizons and look for value and opportunity wherever it may be.

Read more from David Fabian, Managing Partner at FMD Capital Management:

Four Must Watch Trends In Fixed-Income ETFs

How to Play Consumer Discretionary Stocks

The Best ETFs To Navigate Choppy Interest Rate Waters


Twitter: @fabiancapital
No positions in stocks mentioned.
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