A Repeat of the 1987 Crash?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It's understandable that investors might take anything that Marc Faber, editor of the Gloom, Boom & Doom Report, says with a grain of salt based on the pessimistic name of his newsletter. However, his call for either a correction now or an 1987 style crash later in the year comes on the backs of other notable investors warning of the market risks ahead. What's an investor to do?

Look Out Below

Faber recently spoke with Yahoo! Finance about his notably pessimistic outlook. His call is for a meaningful correction now or “a repeat of 1987 when stocks rallied 40% into summer only to collapse 41% in 2 months.” Neither outcome sounds that great. It would be easy enough to dismiss the newsletter writer as being dramatic in an attempt for some free publicity if statistics didn't back him up.

The Numbers

John Hussman of the Hussman Funds is a market watcher who likes to dig into the numbers. He doesn't try to predict the market, instead categorizing different periods together based on similar characteristics, such as valuations and investor sentiment, among many others. Hussman's research suggests that Faber is on to something.

From a recent weekly commentary: “Last week, Investors Intelligence reported that the percentage of bullish investment advisors increased to 54.3%, with bears contracting to 22.3%. Vickers reported that corporate insiders are again selling at a nearly frantic pace of 9.2 shares sold for every share purchased, and the NAAIM survey reported that the average overall equity exposure reported by active investment managers reached 104.25% at the end of January – a leveraged position, and the highest figure in the history of the survey.”

These are all bad signs that back up Faber with some solid facts. One more Hussman quote is even more frightening: “No. We've been here before, and the consequences – though not always immediate – have invariably been bad. There is not a single instance in historical data since 1871 when the S&P 500 traded above 18 times record earnings and there was not a low a year or more later...”

That quote was from February of 2007. While that observation proved to be a few months early, as the market continued higher until late in the year, there is no question about how damaging the market crash that lasted until early 2009 turned out to be. Hussman sees many similarities between 2007 and today.

OK, I'm Scared

When the market is hitting all time highs and far too few people see any reason to expect anything but higher prices, investors should be scared. Unfortunately, if you are trying to live off of your investments, you don't really have the option of sitting on the sidelines. If you don't own dividend paying stocks, you get no dividends. What to do?

For starters, it is important to remember that stock prices are driven by emotion over short periods of time. So focusing on a company's fundamentals may lead you to great companies, but not inherently appropriately priced ones. Look no further than the Apple's share price advance and subsequent fall for evidence of this.

Reduce Risk

With this in mind, it might make sense to reduce risk. If you have been stretching for yield, pull back. For example, shares of Pitney Bowes (NYSE: PBI) have been hard hit of late because the company's legacy business is being eroded by the Internet. While the company is working hard to catch up to the times, launching several online initiatives, there is still a notable possibility that it won't be able to adjust to the new world order. Investors clearly aren't impressed with the company's efforts so far. While a dividend yield in excess of 10% might be enticing, conservative investors should avoid this one. And, income investors should keep in mind that there is a new CEO at the company, which often precedes a dividend cut as the new leader tries to dump as much bad news as possible on the backs of the old management team.

Aside from reducing risk by avoiding more aggressive investments, it might also make sense to take some profits off the table if you own stocks that have appreciated materially over the last few years. For example, International Business Machines has gone from around $80 a share during the bear market to a recent price of around $200 a share. While the yield at the low point might have been worthwhile, the more recent yield of about 1.7% is far less compelling. Selling a portion of the position might not be such a bad idea.

Make a Watch List

The next thing to do would be to create a watch list. Look at the companies you wish you owned and decide at what point they would be buys. Clearly, focus on each company's fundamentals and not the market's perception of the entity. Here are some companies that might be worth keeping an eye on:

Realty Income Fund (NYSE: O)

Realty Income Fund is a real estate investment trust that owns triple net lease properties. This lease structure allows the company to collect rent while requiring the renter to foot all the bills and responsibility for a building's upkeep. It is among the largest players in the space, which not only gives it economies of scale, but allows it to cherry pick its purchases. During the bear market, the shares reached a nadir at a point that left it yielding around 10%. Today, it yields about half that.

There's no doubt it's a well run company, but it's probably too pricy at these levels. Keeping this one on your watch list, however, would be a good idea. That's particularly true for dividend investors looking for a monthly paycheck, since Realty Income Fund pays its dividend monthly.

Johnson & Johnson (NYSE: JNJ)

Johnson & Johnson is one of the world's largest healthcare companies with an enviable history of growth and annual dividend increases. The just completed year was a solid one for the company that seems set to lay the foundation for more rapid growth in the next few years. Indeed, the company's research and development efforts appear to be paying off as its roster of new drugs is strong. Moreover, it has a collection of promising drugs working through its pipeline.

In addition, a major acquisition in the medical devices group is progressing smoothly. And the Manufacturing problems in the company's consumer products group seem to be nearing an end.

After struggling through a few rough years, it looks like JNJ's business is at a turning point. That could make 2013 a very good year. Since the company is in the medical field, its products probably won't be as impacted by a market correction as companies more reliant on conspicuous consumption. The shares are already at an interesting valuation point, recently yielding a little over 3%, however, if the market corrects, investors could find themselves with a 4%+ yield very quickly.

IAC Interactive (NASDAQ: IACI)

IAC Interactive is a more aggressive option. The company has made a business of both finding new Internet ideas to grow and buying struggling Internet companies that it believes can be nursed back to health. The company's goal is to monetize the traffic across its various web sites. For example, it recently purchased Tutor.com.

That company is a relatively obscure, but notable, competitor in the online tutoring space that connects tutors and students. While the media made a big deal about IAC using its Match.com dating service's algorithms to pair students with tutors, that isn't what the deal was about. Tutor.com had done a relatively poor job of advertising with the public. IAC looks to change that using its collection of sites.

The interesting thing about IAC is that it owns a diverse collection of websites that span multiple categories, from dating to search to special interest to humor. It has done a great job of turning its large collection of brands into a recurring revenue stream. It's fair to suggest that the Internet isn't a fad and owning a well positioned “portfolio” of web sites seems like a good idea.

Since the company introduced a dividend a year or so back, and increased it once already, more aggressive dividend investors looking to get some Internet exposure might want to keep an eye out for a share price drop.

Fear and Fortune

There are some really good reasons t be nervous about today's markets. While it's never easy to go against the crowd, it might make sense to at least start preparing for the worst. A little insurance never hurt anyone.

Yours,
 

<img src="http://g.fool.com/editorial/images/19328/signiture_large.jpg" />


Reuben Gregg Brewer owns shares of several Hussman Funds and shares of Realty Income Fund. The Motley Fool recommends Apple and Johnson & Johnson. The Motley Fool owns shares of Apple, International Business Machines., and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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