Our only concern when it comes to the stock market is that the sentiment of investors has clearly turned sharply to the positive.  While that, in and of itself, is not a reason to avoid stocks (since it can go on for a long time……years in some cases), it does raise the possibility of a shorter-term correction in prices to test the resolve of the new money in the market.  The chart below shows the Investors Intelligence Bull/Bear Ratio.  After spending the last half of 2011 and most of 2012 in negative territory (more bears than bulls among individual investors), the ratio has risen steadily since the market’s low in the summer of 2012 and is now close to the level from which we see stock market pullbacks in each of the past three years.

Investors becoming Bullish

This is not an indicator that you want to base your entire investment strategy on, since it is more of a short-term trading tool than a market valuation measure.  However, despite our longer-term bullishness, many stocks have moved too far, too fast in the past six months and we have substantially reduced our stock exposure in the financials, consumer and soft commodity sectors.  We have maintained positions in the gold and energy stocks as these groups have lagged the overall market gains and are most under-valued relative to historical levels.  Gold in particular should act better as a ‘risk-off’ investment as central banks have been buyers on the recent weakness and much of the ‘hot money’ that fueled gold’s advance has exited (in a highly visible way) in the past few months.  In our Balanced Funds we have moved to a ‘neutral stock’ position for the first time in two years.  Excess funds are being kept in cash rather than invested in bonds since we expect to be back adding to stock positions within the next few months (or weeks if the correction comes even earlier).  In our Hedge Fund we have gone to a ‘net short’ position in stocks for the first time in five years.  Again this is more of a short-term call and we have offset short positions in the U.S. and German markets with ‘long’ positions in the Canadian Gold and Energy sectors.

It must seem paradoxical to outline such a bullish longer-term case for stocks and then finish with the strategy that we are positioned more bearishly than we have been in over two years.  However, we are active investors and have seen many short-term indicators move to ‘over-bought’ levels, in much the same way as we have at this time of year over the past three years.  It might be a little early to be invoking the ‘Sell in May and Go Away’ rule but we have seen these circumstances occur before and realize how quickly investor sentiment can turn back down, and take stocks along for the ride.  Banks and consumer stocks are now reflecting almost all of the good news around them and the valuations have recovered most of what was lost in the downturn.  However, we are only ‘slightly underweight’ stocks right now.  Our longer-term bullishness keeps us from wanting to make this a larger call since the timing of such a correction is always difficult.  The bottom line is that we expect to be overweight in stocks for most of the next few years since stocks offer better longer-term returns right now than either bonds or cash.  But that won’t necessarily stop stocks from seeing a pullback after such a strong run.  Our top sector picks for the longer-term remain Technology and Industrials, but we would also look to add to the Telecom sector on any pullback (it remains a great longer-term story but is currently trading at record-high valuations).  We would also add back to the Financial sector in both the U.S. and Canada on any significant weakness; U.S. banks in particular will benefit from the continued recovery in the housing market.  In the short term, however, the Gold and Energy stocks have been the big laggards over the past two years and should protect capital better in any market correction.  That also means that the Canadian market should be ready to play some ‘catch-up’ on a relative basis.  We look forward to updating our thoughts on these markets in the near future.   Fasten your seat belts!

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