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What will you do when the bull market tops out?

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I have no idea when the bull market on Wall Street will come to an end.

But when it does, you almost certainly won’t believe it. Along with the rest of Wall Street, you will be caught up in the euphoria that accompanies a late-stage bull market.

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This is of more than just theoretical significance. It’s been more than a month now since the stock market hit an all-time high, and it’s possible that the bull’s last gasp was registered then—and that a new bear market has already started. Yet few seem willing to even entertain that possibility. While that doesn’t mean that a new bear market has started, it also doesn’t mean that one hasn’t.

In other words, your emotional state is an unreliable guide to managing your equity portfolio. If a bear market would inflict intolerable damage on your retirement finances, you therefore should act now to reduce your equity exposure level to whatever your comfort level may be—even if it seems crazy to reduce your exposure now.

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Consider the mood that prevailed at the tops and bottoms of all bull and bear markets since 2000 (there have been five of each, according to the calendar maintained by Ned Davis Research). The accompanying chart shows market timers’ average recommended equity exposure levels at those tops and bottoms, as measured by the Hulbert Stock Newsletter Sentiment Index (or HSNSI).

Notice how the timers as a group were far more optimistic at highs than they were at lows. On average, these timers’ recommended equity exposure level was 72 percentage points higher at market tops than at market bottoms.

This is just the opposite of what would have been helpful, of course. This is why Warren Buffett, CEO of Berkshire Hathaway
BRK.A,
+5.45%

 
BRK.B,
+5.73%
,
 famously once said that our job is to be fearful when others are greedy and greedy when others are fearful.

Anecdotal evidence

While I think these data tell a powerful story, many of my subscribers find anecdotal evidence more compelling. So I want also to offer a sample of relevant quotations at past bull market peaks.

The particular quotations below were made by investment newsletter in early October 2007, just as the 2002-2007 bull market was coming to an end and the Financial Crisis was beginning.

To refresh your memory, the Dow Jones Industrial Average
DJIA,
+3.86%

 over the subsequent 17 months would lose 54%; the S&P 500
SPX,
+2.77%

 would lose 57%. Even though the market was about to go over that cliff, here’s what a number of newsletters were telling their clients:

• “The global bull market in stocks not only continues, but…it’s also entering a strong phase…Now that the Fed has waved the flag that interest rates are going lower, there’s really nothing holding the market back.”

• “[I]t appears to us that the stock market is off to the races for the next 3 to 6 months.”

• “The risk of a cyclical bear market decline in excess of 20% is not on the radar screen.”

• “The longer-term bull market is intact…You should be looking to buy on any weakness.”

• “It’s been a while since I’ve felt so confident about the potential for making some great gains with our serious money. So, if you haven’t done so already, it is essential that you get your money into this [stock] market as quickly as possible. Time waits for no man, and your money is waiting on you. So go to it.”

• “If you listen carefully, you can hear the rumbling. That rumbling is the distant thunder of the third phase of this great bull market…I see the good times rolling, I really do.”

Notice that I didn’t identify the market timers who made these comments. That’s because my point is not to embarrass them. They instead reflect a universal human tendency to be giddy and optimistic at market highs.

Rather than smugly judge them for what, in retrospect, seems like the height of folly, we should recognize that all of us are susceptible to the same emotional forces.

How to react

So bear all this in mind as you contemplate your retirement portfolio today. Engage in some honest self-reflection about what a major bear market would do to your retirement financial security—and your peace of mind.

While you are engaging in that self-reflection, keep in mind that the average bear market since 1900 produced a 31% loss in the Dow Jones Industrial Average. This past February-March’s waterfall decline led at a 37% loss in the Dow.

If you decide that you are too exposed to the equity market, you have several options in addition to selling your stocks. You could, for example, shift some or all of your equity exposure to more defensive stocks. Just don’t kid yourself that you’ll know when the market is topping and therefore can wait until then to take these defensive moves.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.



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