Time to Sell Stocks?

After the market closed on July 17, with Standard & Poor's 500-stock index approaching yet another record, strategist Steve Leuthold issued a "sell" recommendation to clients. His Minneapolis-based market research and money-management firm lowered the percentage of exposure to stocks in its portfolios to 30%.

Leuthold conceded in the memo that he felt odd. "We must admit it is unusual and somewhat strange to ... shift to negative at the same time almost all stock market indices are recording new highs and the global economy is stronger." Indeed, the indicators surprised him and his colleagues so much that they waited a week and rechecked the data before issuing the memo.

A few days later, Leuthold looked like a genius. It's not the first time. Leuthold called the start of the current bull market almost five years ago with stunning accuracy. Other accomplishments in a long career include getting clients out of stocks before the 1987 market crash, when the Dow Jones industrial average plunged nearly 23% on a single day.

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No, he's not perfect. He incorrectly advised investors in 2005 to cut back their stock weightings to 30% of assets -- only to later change his mind when the market continued to rise.

But his record has been so good that I consider him my favorite market strategist. Unlike low-rent market timers, Leuthold doesn't just look at a few bits of market data -- such as the market's momentum or interest rates or investor sentiment. Instead, he examines more than 180 factors. And he doesn't restrict himself to technical indicators, such as the direction of the market or the numbers of advancing and declining stocks. Leuthold also looks at fundamental factors, such as how expensive stocks are based on earnings, as well as data on the economy, interest rates and inflation.

For many months, Leuthold has been concerned that economic growth was slowing, that interest rates and inflation were headed higher and that investors were too optimistic. When investors are mainly optimistic about stocks, the thinking goes, the market has nowhere to go but down because everyone who was planning to buy already has. "Name me one pundit who was bearish?" challenges Chuck Zender, a senior analyst with Leuthold. "There weren't any bears anymore except the perma-bears."

The final piece was market breadth. That is, even as the indexes were setting records, fewer and fewer stocks were making new highs and the ratio of advancing stocks to declining stocks was falling. "There were really only about 250 stocks going up before this correction -- and nothing else," Zender says.

What's next for the market? If Leuthold is right, the next step is a bear market but not a catastrophic one. On average, the stock market suffers a bear market -- defined as a drop of 20% in major indexes, such as the S&P 500 -- every four or five years. During an average bear market, the S&P loses about 25% of its value. It usually takes 11 to 18 months for the market to hit bottom.

Every generation, investors suffer a cataclysmic bear market. In both the 1973-74 and 2000-02 bear markets, stocks plunged almost 50%. During the Great Depression, the market was down 89% at its worst.

But Leuthold expects the declines to be tempered this time around. First, stocks aren't ridiculously overpriced, as they were in early 2000. And although economic growth appears to be slowing, the most recent figure on the pace of expansion showed the economy to be quite healthy, thank you (gross domestic product expanded 3.4% in the second quarter). "Besides, we just had one of those big bear markets," Zender says.

What should you do?

First off, take any market prognostication with several large grains of salt. In a note to clients penned just before the selloff, Harold Evensky, a financial planner in Coral Gables, Fla., laid out a laundry list of reasons why stocks should decline, then said he wasn't selling.

His reasoning: "We believe successful market timing is significantly less likely to succeed than picking the winning lottery number. Why are we such skeptics? A long history of research has demonstrated that markets not only drop precipitously, they also recover quickly. Market timers must make not one, but two accurate predictions. A timer not only has to be correct in determining when to exit, he or she must also correctly time re-entry."

I couldn't have said it better. Still, Leuthold has a terrific record, and I wouldn't dismiss his forecasts out of hand. So, I wouldn't argue vociferously if you wanted to sell 10% or so of your stocks and move the proceeds into a money-market fund for a time.

As for me, I'm not selling anything. But I already have rearranged my portfolio -- and again urge you to do the same. I've cut stocks of small companies to 10% or less of my stock investments and raised my stake in stocks of large companies. It's common sense; most large companies are a lot better equipped than small companies to face economic and market turmoil. Among large companies, those that exhibit relatively strong growth are more attractive than value stocks. I'm also keeping 25% to 30% of my stock money in foreign stocks.

My favorite large-cap growth funds include Vanguard Primecap Core (symbol VPCCX) and Marsico Growth (MGRIX). Use Selected American Shares (SLADX), despite its huge weighting in financial stocks, for the less-growthy part of your big-cap allocation. Dodge & Cox International Stock (DODFX) remains the best-looking foreign stock fund.

There's no room for low-quality bonds in my investments. High-quality municipal bonds, such as those in Vanguard Intermediate-Term Tax Exempt (VWITX) are ideal. And there's nothing wrong with sticking some cash in a money-market fund.

Don't expect to make money in a bear market this way, but you'll almost certainly lose less than you would by owning riskier fare. And if Leuthold turns out to be dead wrong, as he was in 2005, I think you'll do just fine with the same group of funds.

Steven T. Goldberg (bio) is an investment adviser and freelance writer.