SATURDAY, NOVEMBER 23, 2013
Time to Prune Your Stock Portfolio
By JACK HOUGH
 
With stocks getting pricey, consider trimming U.S. shares and small- caps, but hang on to Europe and emerging markets.
 
U.S. stock prices are at record highs, even as the Federal Reserve is poised to remove some of its supports.
 
Sooner or later, the Fed will wind down its massive bond purchases, which have held down yields, making stocks look attractive by comparison. So is it time to sell?
 
That's a delicate question. If the tapering begins sooner than expected—say, in January rather than in March—or if bond yields rise too quickly, share prices could tumble, even though long- term fundamentals look good, says T im Leach, chief investment officer at U.S. Bank Wealth Management.
 
Cautious investors may wish to raise a bit of cash to help offset those risks, or simply to rebalance their portfolios. The Standard & Poor's 500 index has surged 26% this year, likely leaving many investors with a higher mix of stocks than they would prefer.

That raises two questions: what to sell and where to put the cash.

Selling decisions should be made on a case-by- case basis, according to valuations and growth prospects, but in general, trim U.S. holdings before overseas ones and small companies before large. As for a liquid place to park the cash, bypass money-market sweep accounts offered by brokers in favor of money-market accounts at banks. It's an easy way to earn 1% instead of nothing—and that 1% will look pretty good if stocks and bonds suffer a pullback.

The Standard & Poor's 500 index trades above 17 times trailing earnings, versus a historical average of about 15. And earnings growth has slowed to a casual pace, 3.4% year over year in the third quarter versus a year ago, on 2.9% revenue growth. Faster economic growth could help;
U.S. output should rise 2.9% next year versus just 1.7% this year, according to forecasts released on T uesday by the Organization for Economic Cooperation and Development. In the meantime, cash-stuffed companies can use share repurchases to plump up their earnings per share. As for valuations, bull markets often far overshoot average levels, suggesting the rally has room. Bull runs that began in 1982 and 1990 led to stock gains of 49% and 83%, respectively, after the market had reached average price-to-earnings ratios, according to JPMorgan.
 
In other words, investors who are tempted to cut their stock exposure should prune, not chop.
 
OVER THE PAST THREE years, the MSCI USA index has returned an average of 14.4% a
year, versus 5.2% for MSCI Europe and a 3.3% yearly loss for emerging markets, as measured by the MSCI EM. Price-to-earnings ratios understate differences in valuations, because U.S. profits are hitting all-time highs while those in Europe are beginning to recover from cyclical lows. If Europe achieves 15% earnings growth next year, it will still be 25% below trend levels, suggesting more room for improvement, according to a recent analysis by Bank of America Merrill Lynch.

Taking a long-term average of earnings to adjust for cyclicality, U.S. shares are 57% more expensive than emerging markets and 67% more expensive than Europe, according to data provided by Mebane Faber, chief investment officer at Cambria Investment Management.
 
Within the U.S., look first to small companies for profit-taking. They've done much better than large companies this year: T he S&P SmallCap 600 index has soared 35%. One reason investors have favored them is for their relatively low overseas exposure, but as Europe gradually recovers, that could shift from a tail wind to a head wind. Also, while it's normal for small companies to fetch higher price-to-earnings ratios than large ones because of their potential for faster growth, the premium recently stretched to 20%, versus a long-term average of 4%, according to BofA.
 
Investors who own shares of mostly large companies should look for profit-taking opportunities among those with high dividend yields and modest growth potential. These include staples, telecoms, and utilities. T heir steady income, while usually welcome, can cause them to trade in sympathy with bonds, which isn't especially desirable at a time when the Fed is set to wind down support for the bond market.
 
INVESTORS WHO PARK their sales proceeds in money-market funds offered by investment companies can expect pitifully low yields. The Crane 100 Money Fund index recently yielded 0.02%. Safe, short-term bonds are another option, but also pay little because a recent rise in bond yields has done nothing for short issues. The 10-year Treasury yield has climbed nearly a full percentage point this year, but the one-year yield has fallen slightly, to 0.12%.
 
Look to banks for better options. Investment companies face strict rules on the assets they can hold in money-market funds, but banks, which offer money-market accounts, simply set rates low enough to earn a profit on loans but high enough to attract deposits. Sallie Mae and GE