The Sound of Speculation

“Hello darkness my old friend,
I’ve come to talk with you again …”

So begins the 1960s Simon and Garfunkel hit “The Sound of Silence.” If the stock market were a singer-songwriter, that darkness might represent one of the worst traits of investor behavior, and something that the market returns to in almost every cycle: excessive speculation.

Speculation is a link between the careless greed of a bull market and the overpricing that comes crashing down in a bear market. Five years into the current bull market, this is a good time to listen for the sound of speculation in the market. You won’t have to listen very hard.

Three sounds of speculation

1. M&A activity picks up. There are indications are that merger and acquisition activity has returned to pre-financial crisis levels. There is nothing wrong with the occasional merger or acquisition, but when too many managers are turning to it as a corporate strategy rather than organically growing their markets or market share, it is a signal that there is not enough actual growth to go around.
2. Investors are grasping at IPOs. Initial public offerings are a good ways for young companies to raise capital to expand, but ideally they take place when there is at least some positive earnings history to demonstrate a viable business model. Otherwise, investors are simply buying the hope that the company will succeed on a larger scale at what it failed to make profitable on a smaller scale. Reuters recently reported that, according to an IPO expert at the University of Florida, IPOs for money-losing companies have reached a 14-year high. Fourteen years ago, you may recall, was about the time the dot.com boom collapsed.
3. Subprime lending is back. The New York Times reported earlier this month that subprime lending in auto loans has returned to pre-financial crisis levels, and signs of stress — in the form of delinquencies and defaults — are starting to show in the sector.

Protecting your portfolio

Almost by definition, financial markets involve some element of speculation, and even excessive speculation can go on for years before prices come crashing down. So, it’s not wise to go running for cover as soon as you see speculation getting out of hand. Instead, it should be seen as a sign to start making gradual moves to steadily edge your investment position toward safety. Here are some examples:

1. Rebalance your holdings. Between strong stock returns and lackluster savings account rates and bond yields, you might find your stock allocation has gotten a little ahead of everything else. Trimming it back will help you avoid disproportionate losses as a result.
2. Rotate sectors. Technology is a particular favorite of speculators, so this might be a good time to switch some money out of tech and into more conservative sectors of the market.
3. Focus on the operating earnings strength of your stocks. One way to separate hype from reality is to look at the operating earnings growth in your stocks. This helps you see how they are doing at their fundamental businesses, rather than as a result of market speculation or accounting tricks.

Speculation may be a normal part of the market cycle, but there is no reason why it has to be part of your investment approach.