With investor sentiment bubbling at levels comparable to just before the market's historic highs in 2007, now may be the time to pull back some before the froth gets out of hand.
Strategists are almost universal in expectationsfor the market to climb from 10 percent to 20 percent in 2011, and investor polls show bullishness around 60 percent. Those are numbers reminiscent of October 2007, just before the worst of the financial crisis hit and the market lost more than half its value.
At the same time, stocks have been climbing steadily higherduring what is a normally great month, rising 6 percent even on low volume. Finally, more than 3,400 new highs have been hit this month on the New York Stock Exchange.
It's at just such times of massive exuberance that the market is poised for a letdown.
"One of the things that increases the risk is indeed the rise in optimism," says James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis. "We're still going to have a decent year, but I think the risk is higher going into the year than it's been."
Peaking investor sentiment and nearly unfettered runs higher are, almost by definition, what precedes market falls. Feeling that the best of the market has been achieved for the moment, investors itchy to take profits step in and sell their shares.
The good news is that such selloffs lead to buying opportunities and are thus only temporary, except during chronic bear markets.
So while hesitance such as Paulsen's is creeping more quickly into the market, it's still not changing the overall bullish scenario for the year ahead.
"I'm thinking we're going to have a correction the second or third week of January—a nice correction of 5 to 7 percent. Everybody is way too bullish," says Dave Rovelli, managing director of US equity trading at Canaccord Adams in New York. "We're melting up on no volume."
The trick for investors, then, will be how to take some downside protection while not missing out on any further moves higher.
Strategies are breaking into two camps: Taking money off the table before the end of the year and waiting for a substantial dip to provide another buying opportunity, or grabbing for safety, such as in bonds, and employing a buy-and-hold bunker mentality to ride out volatility storms that could erupt in what for months has been an uncommonly complacent market.
"I'd definitely put some stops in just so you can buy again," Rovelli says. Fed Chairman Ben Bernanke "has been putting all this money into the system and people are going to buy equities. So you buy, but the trade is you take some profits and then wait to buy some more."
Similarly, Citigroup's chief investment strategist, Tobias Lefovich, is advising clients that "thinking like a trader rather than an investor is still appropriate as a new secular bull market does not seem probable quite yet."
"[A]n overshoot above and beyond our conservative S&P 500 year-end 2011 target of 1,300 is very plausible and a run to 1,400 or higher cannot be ruled out, but we struggle with its sustainability..." Lefkovich wrote in a note to clients. "Note that we have seen strategists around the Street bump up outlooks recently in what appears to be a bidding war for even more bullish views."
Such optimism, he wrote, means "the related upside surprise factor is diminishing," so some of the anticipated 2011 gains on economic strength already have been priced into the 2010 market.
Trying to time the market's gyrations, though, is a difficult endeavor, and some, like Paulson and Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati, think investors need to be careful about getting too driven by contrarian signs.
Fund flows, after all, are showing that money is still coming out of domestic equity funds, signaling that while polls may show high investor sentiment, behavioral patterns do not. Equity funds took in $3 billion over the most recent six-day period, showing growth for only the first time since April.
"There's an interesting dichotomy. They may say they're bullish, but their money doesn't say they're bullish," Detrick says. "We'd have some pretty tight stops. But we wouldn't necessarily go out and sell everything, because this can continue for another month."
Instead, investors may want to shift some allocations, putting some money into Treasurys, which have been getting beaten up latelybut remain a safe haven.
"Every investor should have long-term parameters that set up diversification guidelines, and you should never violate those," Paulsen says. "I still own Treasury bonds even though I hate them. I do that because I know I am going to be wrong over periods of time, and that protects you from yourself. What you should really strive to get right over time is the longer-term investment strategy."