SUMMARY.  A variety of indicators suggest that you should be taking profits in some areas, and re-balancing towards others where there is obviously more value, or outstanding long term growth potential.

Back in August we highlighted that the UK stock market appeared to be losing momentum, but that you didn’t need to panic even though many world stock markets up in excess of 50% since March 2009. Since then markets have gone a touch higher, and a series of warning signs have now emerged:

• One useful long term indictor which has got us out of trouble over the years is the “average gap” i.e. how far the market is running above its long term trend as measured by the 200 day moving average. Recently it has been more extended than at any time since before the Crash in 1987.

• Analysts in the US are getting spooked by Treasury yields going lower (signalling deflation) while stock markets have continued going up (signalling growth, and possibly inflation). Back in 1987, 1994, 1998, 2000, and 2007 such divergence preceded sharp falls in equities.

• Valuations are stretched in many cases, particularly if based on cyclically-adjusted price earnings ratios, suggesting the US market is 35% overvalued (and not forgetting that the yield on the US market is not as high as before the Crash in 1929!).

• In the absence of retail investors (who are predominantly buying corporate bonds) the pivotal buyer of equities appear to be hedge funds, who are not long term buyers, and if they rush for the exit there could be sharp falls.

• Markets have been driven up by a small number of sectors that appear to have limited upside from current levels e.g. banks and miners.

Last but not least there appears to be complacency, based on the recession being over (hopefully), with little thought as to how the economy will perform post-recession e.g. with considerable pressure from rising taxes, falling Government spending, high levels of consumer debt, and the risk of sharply falling sterling triggering a rise in interest rates earlier than the Bank of England might like.

This overview could spook you. But market exuberance and sharp corrections over shorter periods are part of what long term investors must accept (even endure) if you also wish to enjoy the long term rewards. On the one hand you require the mental strength to cope with sharp swings in prices, and on the other hand should not leave yourself too exposed when risks are clearly rising and valuations appear stretched.

There is continuing value in some equity income funds, as we highlighted last month e.g. Newton Higher Income. Corporate bonds still have attractions, and Asia and emerging markets are still likely to be the long term high growth sectors.

So don’t be afraid to take profits in some areas, and re-balance in favour of the latter sectors, the precise balance being dictated by your attitude to risk.