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Investing in a frothy market that might keep rising

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Depending on one’s point of view, U.S. equities are either midway through a secular bull market or teetering on a frothy peak.

Obviously, clients don’t want to see their investment portfolio tank as happened in 2008 to 2009, but they also don’t want to miss out if the market keeps reaching new heights.

Strategies exist to deal with either eventuality, but there is a problem. One could for example move a client’s assets into cash, eliminating any downside risk and setting the stage for buying back equities if the market tanks.

Of course if the market, instead, continues to rise, that client could miss out on enormous gains. Similarly, one could ride the bull, buying on sentiment or cautiously buying companies with strong fundamentals, but what if the market were to suddenly fall off a cliff?

Having it both ways isn’t easy, and there are costs and tradeoffs to any strategy. But Jeffrey Saut, chief investment strategist at Raymond James of St. Petersburg, Florida, insists that it can be done.

“One strategy is to sell long-dated out-of-the-money calls and then buy put options against the same securities,” says Saut, who is also managing director of equity research.

Such a “covered call” approach is offered by hedge funds and some mutual funds. It offers both downside protection and the chance to reap gains on the upside, but this strategy needs management.

Saut also suggests buying inverse exchange-traded funds as a hedge. Neither strategy is suitable for unsophisticated investors, though.

Saut, it should be noted, was worried about a market correction in August and still doesn’t call himself “full-term bullish,” but he is convinced that the shift to a technology-based economy means “[price-earnings] ratios are not high at all the U.S,” saying, we’re just midway through a secular bull market that could run seven more years.”

For those uncomfortable with complex strategies, Roger C. Davis, chief executive at Woodridge Wealth Management in Santa Monica, California, suggests an approach that his company uses of allocations to cash, alternatives and tactical investments.

“We are currently 6% cash for most of our client portfolios,” he says.

But Davis says that in this environment, alternative investments, too, typically one-third of Woodridge portfolios, must be in assets such as merger arbitrage, which are readily convertible to cash.

Most of the rest of Woodridge Wealth Management portfolios are in the tactical allocation bucket both as ETFs and common stocks, the latter being carefully managed on a company-by-company basis.

“We try to capitalize on positive trends as long as possible, but before we buy anything, we define when we’ll get out,” Davis says. “If the whole market begins to drop, leaving no alternate stocks to buy, we end up holding large cash positions.”

This story is part of a 30-30 series on navigating the growing world of choices for client portfolios.

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