“The stock market can remain irrational longer than you can remain solvent.” Famed economist John Maynard Keynes is right. And there is much evidence to support claims that investors are behaving irrationally. In some cases, stock valuations are trading at their highest levels ever.

Investors are more exposed to markets than ever before, and their portfolio cash allocations are running at their fifth-lowest level on record.

At the same time, households are allocating more to equities than at any time since, at least, 1945. You can see that in the chart below:

US equities exposure graph

(Click here to view larger image.)

So, despite nosebleed valuations, investors are as bullish as ever. Which brings me back to Keynes’ observation that irrational behavior can last a long time in the market. And we have herd mentality to thank for that.

Said another way, fear of missing out — FOMO — is omnipresent in the markets today.

So now investors face a tough choice: get out of stocks or follow the pack?

Let me show you a few things I’ve learned in the last epic stock market bubble … and how to come out ahead without a second thought for the herd.

Lessons From a Bubble

Lesson No. 1: You can’t pinpoint the top.

Back in 1998, there were many signs of excessive speculation, but the herd kept on going. If you sold then, you missed out on incredible 21% gains in the S&P 500 the next year.

Lesson No. 2: Herd behavior can create tremendous buying opportunities in the areas they’re stampeding away from.

During the dot-com episode, there was a huge difference in valuations among different stock market segments. The real bubble was in tech initial public offerings, while shunned corners of the market became cheap … such as value stocks.

In fact, during the year the tech bubble burst, large-cap growth funds fell 34%, while small-cap value funds gained 19%.

Here’s what those lessons hold for today’s market…

How to Profit From the Herd

Signs of irrational behavior are growing more ominous, as I described earlier. But the herd can keep this market going indefinitely.

So instead of trying to time the bust by moving your stock portfolio to cash, consider segments of the market still offering great opportunities.

You must be more selective (smart) and brave (tough) enough to stray from the herd.

That’s what I see in the chart below from JPMorgan. Valuation dispersion is hitting levels that were last seen in 1999. And once again, it’s expensive tech and growth shares that are pushing price-to-earnings ratios to extremes. Meanwhile the cheapest stocks are trading at valuation levels similar to the past seven years:

S&P 500 valuation dispersion graph

(Click here to view larger image.)

That’s why you should diversify your portfolio to include value opportunities.

They’re hard to find, but there are stocks in industries trading at cheap valuations that have strong tailwinds to drive profit growth in the years to come.

In fact, the most recent issue of The Bauman Letter uncovered one such pick in the health care sector. It offers an incredible combination of cheap valuation levels and strong projected earnings growth … and a peer-beating, reliable dividend.

Click here to find out more about our latest opportunity!

Best regards,

Clint Lee
Research Analyst, The Bauman Letter