How to invest in an exuberant stock market without being taken for a fool

In the kingdom of the blind, the one-eyed man is king. That’s why the US stock market, with its high prices and questionable bargains, is where every investor wants to put his money.

Consider the limp alternatives. Invest in ultra-cheap European stocks? Only if you have the patience of Job, and superhuman risk tolerance: the data suggests Europe is sinking into another recession. China? Consumer demand there has imploded, threatening not only that country’s economic outlook but other global markets. Bonds? The Federal Reserve has finally wound up its quantitative easing program; its next step – however small and however many months distant – will be to raise interest rates. When rates go higher, bond prices fall, making them extremely unappealing investments.

These are just some of the reasons Pat O’Dwyer is telling his affluent Miami-area clients that the US bull market – the endlessly rising stock prices born in March 2009 – is less than midway through what he now expects will be a 13-year run.

“It may not be as good as the [streak] we saw in the 1980s and 1990s,” he says, referring to the late 1990s, when the Dow Jones Industrial Average rallied more than 20% year after year. “But this is still a great stock market.”

Other market veterans aren’t quite so confident – or at least are a lot more wary about wanting to keep riding the bull.

For some of them, the stock market’s rollercoaster ride in the first half of October – which, at one point, left the Standard & Poor’s 500-stock index in the red for the year – was more a harbinger of what lies ahead.

“The persistence with which the market had climbed for the last three years or so and the lack of volatility has done what it always does – caused people to calm down and brought back greed rather than fear,” says Jim Paulsen, chief investment strategist and economist at Wells Capital Management in Minneapolis.

“You can’t argue that we have giddy optimism, but there’s a greater sense of calm about the future of stocks than we’ve had before, and you can have a big negative market reaction just as easily when calm is disrupted as you can when exuberance or excitement about stocks is shaken.”

In other words, Paulsen thinks we’re getting a bit too complacent, despite big bursts of volatility when the stock market jumped up and down alarmingly. The worst of these were seen in the summers of 2011 and 2012, when investors fretted about the potential collapse of the European Union and about US fiscal woes, such as the stalemate over raising the debt ceiling.

There also have been times when investor confidence in specific sectors has evaporated. Companies who weren’t delivering strong profits and required huge amounts of investor faith in their future growth were the first targets of this selling back in April, for instance.

What worries Paulsen is that none of these selloffs – not even the weeks-long pain investors endured in 2011, or the sudden resurgence of volatility in early October that sent waves of panic through trading floors – seems to have had much of a lasting impact.

“A correction isn’t a percentage move; it’s more about the psychological change that occurs because it happens,” he argues. “If it doesn’t cause people to be more cautious and less optimistic; to question more; then it isn’t a correction. And the October selloff was so brief, the market came back so fast, that may have ended up boosting confidence.”

Indeed, from its closing low of 1862.49 on October 15, the S&P 500 has since recovered 7.1%. Its current level of 1994.59 is below the highs it reached in September, but isn’t far off the record of 2,011.36 set in that month.

To the extent that investors have returned to the bull market, however, they may not be doing so because they’re in love with certain companies. It’s that there’s no other game in town. “Stocks are getting investor attention as a result of a lack of alternatives,” says Russ Koesterich, chief global strategist at BlackRock, Inc.

Investors, he argues, know they can’t just stick their money under their mattresses or in their bank accounts and stand a chance of being able to retire. They need to invest, and there are few attractive options out there. A rising stock market that is getting long in the tooth and overvalued – and that appears increasingly vulnerable to more of these terror-fueled swings as volatility rises – may not be their idea of a perfect investment option. But what’s the alternative?

The trick to navigating an aging and increasingly grumpy bull market is to treat it with care. Back in 2009, when the economic recovery was getting underway and everything was dirt cheap, it was easy to play the recovery simply by buying a broad index fund, which just passively tracked the S&P 500 index. The rising tide did, indeed, lift all boats.

More than five years later, it’s a different matter. Investors have to pay attention. Not all stocks will rise in tandem.

“We think it’s a real stockpicker’s market,” says Sean Gallagher, chief investment officer of value equities for Goldman Sachs Asset Management. “Sector by sector, there are a lot of opportunities.”

These start in the technology, which his team believes is poised to do well as the corporate world embarks on a multi-year period of spending to upgrade its software and computers – spending that they have been postponing for too long. “Hopefully, we’re at the front end of a capital spending cycle,” he says.

Gallagher’s group also is upbeat about the outlook for financial stocks and some healthcare firms (although he has scaled back exposure to those whose prices have soared this year), and is selectively adding to energy holdings on their recent dip in prices. On the other side of the equation, he is shunning telecom services companies, utilities, materials stocks and real estate investment trusts (or REITs), all of which have seen big gains in value and now look pricey.

And almost every penny of future growth in stock prices is going to be tied to growth in earnings, not to a willingness on the part of investors to pay more for those earnings. That means, Gallagher says, that market gains probably will be more modest – 8% to 10%, he predicts – in the coming year.

But it will be pay to be very, very picky indeed when doing your stockpicking. Because even as consumer confidence has recovered to the highest levels recorded since October 2007, wages and consumer spending haven’t. Retail sales aren’t that healthy, either. Companies are booking higher profits, points out Jack Ablin, chief investment officer at BMO Private Bank, but their revenues aren’t growing as rapidly – a sign that consumers and businesses are still hoarding their cash, the former because they may not have it to spend, the latter because they prefer to conserve it.

Of course, this eventually becomes a problem for the bull market – especially when the capital is confined there, for want of other attractive investment options. “Just as the price of beer goes up when the sailors are in town, so the price of stocks stays high when capital is kept in one market,” Ablin says.

Consider the potential for problems in the apartment REIT arena – one of the best-performing market sectors of 2014. REITs – real estate investment trusts – are a frequent favorite of sophisticated investors. The sector is up 30%, while the S&P 500 is ahead 7.7% so far this year, but one Ablin suggests avoiding. REITs generate income as well as the potential for price appreciation, making them particularly attractive investments.

“But while apartment REITs keep going up and up, the rental income that supports them can only go up so far, because incomes just aren’t going up,” Ablin points out. “At some point, reality is going to hit home hard.”

Investors, he suggests, should ask themselves questions about the businesses and sectors that they’re thinking of investing in. Where do the sales come from? Is the market pricing the stock as if there is no risk of any disappointment?

You don’t have to be a giddy, greedy and irrationally exuberant investor to end up being trampled under the hooves of a bull market. The best strategy when confronted by an aging bull, especially when simply walking away isn’t an option? Be watchful, be prudent, and monitor your portfolio for signs that you may be running foolish risks.