Biotechs, Small-Caps, and IPOs: Making Sense of This Peculiar Stock Market

This Year's Peculiar Market Short Exuberance RiskThe spot price of oil has been eerily steady for quite some time; this is quite unusual for the world’s most traded commodity.

It’s been a peculiar year in capital markets, and there’s definitely an uncertainty in sentiment, especially in the equity market with no real trend for investors to latch onto. It makes me think that equity investors should be proactive now and take a hard look at their portfolios for investment risk.

Speculative fervor has been reduced and while small-cap stocks, initial public offerings (IPOs), biotechnology stocks, and super-high-valued stocks have taken it on the chin, this is not unreasonable for the longer-run trend in equities.

The Dow Jones Transportation Average just hit another record-high and its long-term chart, while impressive, actually looks kind of scary. The capital gains are tremendous since the March 2009 low, which begs the question as to when it’s going to reverse.

Historically, most of the average’s declines have come in the form of short bursts of downside, peppered by several multiyear periods of non-performance.

The stock market is highly unlikely to break down without a commensurate move in transportation stocks. But there is clearly room for downside in these share prices. Delta Air Lines, Inc. (DAL) has doubled in value since just last September.

Caution. Caution. Caution. If you eliminate the bubble capital gains produced by stocks comprising the S&P 500 index during the late 1990s and their price recovery during the mid-2000s, the long-term chart still reveals an incredible performance. The crash of 1987 now looks like a blip. The 100-year chart of the S&P 500 is featured below:

S&P 500 Large Cap Index Chart

Chart courtesy of www.StockCharts.com

Stocks typically are a leading indicator, but considering where they’ve come from in terms of share prices, it’s time to be highly cautious and make sure your portfolio is heavily weighted to quality. Risk is now more important than potential return as everything’s already gone up.

I think corporate earnings were quite a bit better than expected in the first quarter. Late last year, earnings expectations came down significantly but a lot of big corporations came through anyway.

Balance sheets continue to be very good and the cost of capital extremely low. But this is priced into the marketplace.

My worry is that the correction hasn’t happened yet. Stocks went flat in the beginning of 2011 for about a year and a half, then resumed their uptrend—with fervor.

A full-blown stock market correction would actually be a healthy development for the longer-run trend. (See “Top Stocks Poised for More Gains in Slow-Growth Market?”)

I view 2013 as having been a breakout year for stocks, as prices were able to convincingly break out of their previous cycle, which was at a recovery period from the 2000 technology bubble.

Within a secular bull market, the U.S. economy can experience another recession and the stock market can crash.

There’s plenty of “irrational exuberance” in all facets of today’s capital markets and investment risk with stocks remains high.

Financial engineering produces bubbles, and quality holdings and portfolio safety are critical now, given the incredible capital gains over the last five years.