When the Herd is Zigging, Start Zagging

After 25 years of managing money, one of the best and most consistent lessons I have learned is that you pay a dear price for consensus on Wall Street. I have seen dozens upon dozens of times that when the majority of the people are zigging, you make a lot of money zagging. Let’s get specific.

Stocks in the U.S. are  20% undervalued. Based on where interest rates are right now, stocks should be 20% overvalued. A huge amount of money is on the sidelines and many investors are worried about everything from Europe to Asian slowdowns to stagflation in the U.S. Additionally, an overwhelming number of people are now deciding to wait to see how the election will play out.

The stock market will not go up or down based on who is elected -- it will go up or down based on earnings meeting forecasted expectations. With most people starting to zig and reducing exposure to the U.S. stock market, I suggest you zag. Buy utility stocks and technology stocks and throw a little money into master limited partnerships that trade on the public stock exchanges. I also suggest buying into a diversified bucket of real estate investment trusts.

International stocks need to be broken down by developed, emerging and frontier markets. Everyone is zigging away from the developed markets and, in this case, I agree. However, don't run away from the emerging markets. For the most part they will rise and fall with the worldwide demand for commodity prices. If you believe that we could see a reversal in commodity prices near term, you will see a quick spike in the emerging markets. I would allocate a little money there right now - but not too much. The frontier markets are the area that no one is even looking at. They are highly risky but offer the greatest way to add some octane to your portfolio. Buy the Vietnam ETF and the Nile fund that focuses on Africa. These economies are growing and seem to be insulated from the world-wide slow down.

Government and municipal bonds, which are mainly interest rate sensitive, have the greatest long-term risk of principal. There has been a flight to them from everyone around the world and that has pushed prices up and yields significantly lower. Staying with my theme, investors have been zigging to them. When rates rise , the price of these instruments will drop quickly. Most of these bonds are extremely overbought and I feel very strongly that if you own long maturity government or municipal bonds you should sell them right now. It is time to zag and sell any bonds that mature after 2016, the most sensitive to interest rates rising. It is important to note that the government only controls short-term rates . If you bought any of these bonds three to five years ago or longer you have gains. Secure them now.

Corporate bonds that are rated AAA down to A are primarily interest rate  sensitive and will trade close to lockstep with government and municipals that have the same maturity dates. Many people are reaching to find higher yields in this environment and are dropping down severely on the credit quality scale to capture higher rates and are extending maturity dates to get these higher rates. I believe this is a good move with a portion of your portfolio. For the money allocated to fixed income, where you want income and some safety, I'd put 40% into short duration corporate bonds rated AA to BBB, 40% into preferred stocks, and the remaining 20% into lower-rated bonds. These are corporates rated BB to CCC.

In summary, I have seen it all in my years in this business and it always amazes me how the individual investor does the wrong thing at the wrong time, perhaps the combination of  too much emotion and the fear of losing money. But I think it is time to ignore the consensus and zag.

Ed Butowsky is managing partner at Chapwood Investments and an internationally recognized wealth manager.