For the first time in more than two years, the investing news appears to be unqualifiedly good. The markets closed at a two-and-a-half-year high on Friday. The unrest in Egypt resolved peacefully. Mergers and acquisitions are picking up again. Even so, a small cadre of doomsayers say there is still plenty that could go wrong – and missteps that smart investors can avoid.
No, they're not talking about bonds or gold, which many investors think are due for a pullback. They're talking about small-cap stocks, which are just 6% off their all-time high. Anything vulnerable to inflation could also be a trouble spot, and food prices are at their highest in 20 years. And cash, which has been unspectacular for a while, could get riskier: If inflation picks up and interest rates don't keep pace, your balance may grow, but your purchasing power will erode.
Why all the gloom and doom? After all, it's not a popular position: In January, investors put $17.8 billion into equity mutual funds, the best month for stock funds since May, 2009. But the recent market highs are making some investors nervous, the threat of tumult in the Middle East remains, and we've yet to see if the economy will collapse without government help, notes Richard Madigan, chief investment officer of Global Access Portfolios at J.P. Morgan Private Bank. Meanwhile, interest rates have nowhere to go but up, and recently, the bond market signaled it's expecting inflation. "Don't fall in love with the 'it's all better, it's all over,'" says Madigan. "The macro environment is still significantly challenged."
So where should investors steer clear? Three areas, experts say:
When the Federal Reserve announced it was buying back Treasurys, investors looked for better returns from riskier investments—like small company stocks, says James Dailey, chief investment officer of TEAM Financial and portfolio manager of the TEAM Asset Strategy Fund ( TEAMX ) . The result: the Russell 2000 Index has risen nearly 140% from its low in March 2009. That means there may be little left to gain in the long term, says Dailey: "We would now call them dangerous."
The stocks aren't cheap, either. The average price-to-earnings ratio for small-cap stocks is currently 23, close to levels last seen at the height of the market in 2007, and high enough to push investors to look for better buys elsewhere. And investors should keep in mind that small-caps tend to fall faster than their larger peers should we see a market correction, adds Madigan.
Severe weather and increasing global demand for staple crops like rice, wheat and sugar has caused food prices hit their highest level since 1990. Those higher costs could hurt major food companies, says Russell Croft, co-manager of the Croft Value Fund ( CLVFX ) : He's steering clear of meat providers, who might see their profit margins squeezed as grain gets more expensive. The same is true for cereal companies Kellogg's ( K ) and General Mills ( GIS ) . Some companies may be able to pass those costs on to consumers in the form of higher prices, but then they risk losing business to lower-cost generic brands--a trend first seen during the recession. In the meantime, Croft is playing the commodities boom by investing in companies that serve farmers and agricultural companies, such as tractor maker John Deere ( DE ) , seed producer Monsanto ( MON ) and fertilizer company Mosaic ( MOS ) .
In spite of the above pitfalls, the markets may still be a better place for your money than the proverbial mattress. Money-market funds are yielding a measly .03% and 1-year certificates of deposit pay an average 0.50%. "It's not doing anything for you," says Elizabeth Fell, a fixed-income strategist at Barclays Wealth, the wealth management division of Barclays. In fact, if inflation rises, a cash stash will, effectively, yield a negative real return, because your purchasing power won't keep pace with prices. For investors who still need cash for living expenses, Marilyn Plum, director of portfolio management at Ballou Plum Wealth Advisors, says she's trying to limit her clients' cash to 3% to 5% of their portfolios.
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