Lessons From a Hot Market: Stocks are booming. But don’t get smug. Here’s what you can learn from this year’s rally

Lessons From a Hot Market

Stocks are booming. But don’t get smug. Here’s what you can learn from this year’s rally.

LIAM PLEVEN

Dec. 13, 2013 6:56 p.m. ET

The stock market is teaching investors some valuable lessons in 2013. But in order to make the most of them, you should first acknowledge that this year’s outsize gains don’t necessarily make you a genius. It is easy to feel smart during a broad, sustained rally. Major U.S. stock indexes are up at least 20% to 30% in 2013, on top of double-digit increases last year. Foreign markets are mixed, but Japan and Germany are among those that have risen sharply.Relatively few U.S. companies have failing grades. Only 45 stocks in the S&P 500 have generated a negative return for investors in 2013, through Thursday, according to research firm Morningstar, and the index has risen 27%, including dividends.

“It’s hard to pick a loser,” says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

The downside? Investors could start to believe they have all the answers. In reality, those who expect stocks to keep performing the same way forever are likely to get a rough education from the market.

“People try to use rules of thumb” about how stocks will perform based on past experience, says Adam Parker, chief U.S. equities strategist at Morgan Stanley. “But remember, that can be perilous.”

Still, investors who have done their homework this year have learned a lot about the forces that can push stock prices up and down. They have also learned where to look for potential bargains and why having a widely diversified portfolio is the wisest strategy, given that some lagging stocks have plunged.

Here are 10 lessons you can put to use both when the market is booming and if it starts to fall, in 2014 and beyond.

Steep Rises Don’t Last Forever

In a year when the market raced ahead, hot stocks were often popular among day traders and other fast-moving speculators.

Tesla Motors TSLA +0.12% was particularly popular, and investors who owned shares in the auto maker this year enjoyed a scenic ride. Tesla’s stock climbed to a peak for the year on Sept. 30, and the view was breathtaking—the share price was up 471%.

The stock has since come down from the mountaintop, and the price is now 24% below that high.

None of that says much about where Tesla is going. But it is a timely reminder that most hot stocks aren’t on a one-way journey up. Indeed, Tesla fell 75 out of 188 trading days in the first nine months of the year, according to FactSet.

Investors who can reliably anticipate which stocks will skyrocket are fortunate, and rare. But late arrivers pondering whether to pile in mid-rally should be cautious.

Here’s one way to look at it: Tesla shares were up 353% for the year after the market closed on Aug. 8 and still had a clear road to their September high. But an investor who bought then would have been better off in an index fund. Tesla shares have since fallen 4%, through Thursday, while the S&P 500 has returned 5% over the same period, including dividends.

The World Changes

Newmont Mining, NEM 0.00% a gold producer based in Greenwood Village, Colo., is the worst performer in the S&P 500 this year, down 48%, including dividends. Two other miners, Cliffs Natural Resources CLF -1.18% and Peabody Energy, BTU +0.44% rank among the six companies in the index whose share prices have fallen the most.

Many commodity producers saw their stock prices shoot up during a decadelong rally in commodities. Some observers believed raw-material prices would stay high for years.

Cooler heads noticed the world was changing.

Gold started to lose its safe-haven allure after prices peaked in 2011, as fears of economic chaos and runaway inflation ebbed. That spelled trouble for miners like Newmont. When gold fell 8% in April, the company’s stock price tumbled 23%.

China’s economy slowed, meanwhile, hurting firms such as Cliffs that produce iron ore, used to make steel. Rising supplies of natural gas have dinged the market for coal, which Peabody sells.

Investors might be asking: Which leading sector might suffer next year?

It can be difficult to foresee how a thriving business or industry could falter. But sooner or later, most face unforeseen challenges.

Consider Blockbuster, which dominated the landscape for rental movies before NetflixNFLX -1.17% started delivering DVDs by mail. Last month, Blockbuster—now a unit of Dish Network—said it would close most of the remaining stores.

Not All IPOs Take Off.

Twitter‘s TWTR +6.63% first several weeks as a public company have put wind beneath the wings of investors who think initial public offerings are likely to soar. Not only did the company’s shares pop 73% from their offering price on their first day, they have continued to climb since.

Staying aloft like that is important after an IPO because buying shares at the offering price is difficult if not impossible for many ordinary investors. Typically, they pay significantly more to buy into a hot stock early.

Unfortunately, it’s also not the reality for many IPOs. Many companies quickly come crashing down.

This year through Monday, share prices were higher or flat on the first day of trading for more than three-quarters of the companies that launched U.S. IPOs, according to Dealogic. But only 43% of them rose in the three months after the first-day close (or, for the most recent IPOs, as long as they have been trading).

Investors sometimes like to think of IPOs as a free lunch. Often, what they get is bird feed.

Branding Matters

Some Best Buy BBY +0.70% investors checked out last year, when the company’s chief executive resigned amid an internal probe into his conduct with a female employee and the founder launched a plan to take the retailer private. Shares fell 47%, including dividends.

This year, the stock has rebounded in dramatic fashion, rising 247% through Thursday, including dividends. Despite its problems, which also included the risk that customers would browse in person but make purchases online—known as “showrooming”—Best Buy had a big advantage: Customers don’t view it as outdated, says Oliver Wintermantel, an analyst at ISI Group in New York.

That is no given for a brick-and-mortar chain, as competitors could attest. Best Buy is trying to convert showrooming into sales and emphasizing small appliances with higher margins, says Mr. Wintermantel.

Customers want to examine products they may spend hundreds of dollars on in person, says Amy von Walter, a Best Buy spokeswoman. “Our stores are actually a very big asset,” she says.

Investors who bailed on the stock, Mr. Wintermantel says, failed to understand that a big chunk of last year’s stock-price drop had “nothing to do with performance.”

Buybacks Can Pay—Or Not.

Many investors view a company’s decision to buy back shares as a bullish signal. The tale of two big technology giants this year highlights the risk of treating it as a green light across the board.

The theory is that a buyback, by reducing the number of shares outstanding, will increase the value of the remainder. Indeed, researchers have found that companies which announce share repurchases often go on to outperform.

Apple AAPL -1.09% illustrates how buying into the theory can pay off. The consumer electronics firm’s stock fell from more than $500 per share at the end of 2012 to roughly $400 in late April. But a month after Apple announced it would spend an additional $50 billion to buy back stock, the share price was up 9%. Overall, it has risen 38% since the disclosure, a period when a number of events have affected the company.

But other challenges facing a company can overwhelm any benefit. Cisco SystemsCSCO -1.32% announced a month ago that it would spend up to another $15 billion to buy back stock. The share price fell 11% the next day, as investors focused on a forecast decline in revenue for the computer-networking firm, and they’ve fallen further since.

Spinoffs Can Be Bargains

Many investors also view the universe of new companies spun off by a corporate parent as a good place to look for bargains.

As with buybacks, proponents of the strategy have support from research that shows the stocks of spun-off companies can outperform, particularly as analysts and investors get a better grip on what the new firm does.

In May, Dean Foods DF -0.12% spun off a unit, WhiteWave Foods, WWAV +0.04%which traveled a familiar path for this kind of fledgling enterprise. The price of shares in WhiteWave, which sells dairy, coffee and organic products, fell initially, dropping 9% in the first five weeks or so. But it has shot up 39% since, putting the stock up 27% since the launch, through Thursday, according to FactSet.

As with buybacks, there are also examples of spinoffs that fall flat. As in any bargain bin, there are inexpensive items—and items that are cheap yet still overpriced.

Yes, Content Can Be King

No other company in the S&P 500 has seen its stock rise as much this year as Netflix.

Its 303% gain is particularly striking because two years ago, the company angered customers by splitting its business into DVDs by mail and streaming entertainment online, and charging subscribers more if they wanted to keep both. By year-end, the stock price was down 77% from its midyear peak.

The company began bouncing back last year, as the controversy died down. Now, Netflix’s decision to produce its own shows—including the Emmy-winning “House of Cards”—is helping maintain subscriber growth.

It is clear the company believes in the importance of having a steady supply of whatever customers want most, whether produced in house or not. Netflix is spending “an insane amount of money on content,” says Tony Wible, an analyst at Janney Capital Markets in New York—roughly $3 billion this year.

The investment creates a potential barrier to entry for would-be rivals and could give Netflix pricing power, he says. “We are about fantastic content that is only available on Netflix,” the company says on its website.

Back in 1996, when the Internet was just becoming a force, Microsoft Chairman Bill Gateswrote that “the broad opportunities for most companies involve supplying information or entertainment.” Netflix investors may nod in agreement.

Amazon.com AMZN +0.78% may feel the same way. Last month it launched its own comedy show, “Alpha House.”

But providing content is expensive and risky, and signs of slower growth in adding subscribers could hurt investor confidence. Investors evaluating Internet companies should recall another of Mr. Gates’s points, that there would be “ample failure as well as success in all categories of popular content.”

Paying Too Much Is Asking for Trouble

In early 2013, investors rattled by budgetary brinkmanship in Washington and underwhelmed by meager bond yields bid up stocks in industries that usually weather crises relatively well and pay steady dividends.

What could go wrong? After all, sectors such as utilities and telecommunications are called “defensive” for a reason.

But what made the sectors popular also made them relatively expensive, says Sam Stovall, chief equity strategist at S&P Capital IQ. In March, the ratio of share prices to recent operating earnings among utilities in the S&P 500 was 17.2, well above the 15-year average of 14.7, according to S&P Dow Jones Indices.

That didn’t last. Utilities as a group recently traded at a 15.6 ratio, and the sector is the second-worst-performing part of the index this year, through Thursday, up a mere 7%.

The lesson: “Even with defensive stocks, you need to pay attention to valuations,” says Mr. Stovall.

Heed the Trend

One striking thing about this year’s rally: Thirteen of the 15 companies in the S&P 500 whose share prices are up the most also rose in 2012—11 of them by double digits in percentage terms.

On the downside, many stocks are battering investors for the second year in a row. Five of the index’s 10 biggest decliners in price terms dropped in 2012, too.

Narasimhan Jegadeesh of Emory University and Sheridan Titman of the University of Texas at Austin, found in a 2011 paper that U.S. stocks that perform the best over a three-to-12-month period tend to continue on the same path over the following three to 12 months. Hypothetical portfolios designed to capitalize on the phenomenon made money most of the time, according to the paper.

But the researchers also found a glaring exception. In 2009, in the midst of the financial crisis, the portfolio they built would have lost 36.5%. Other researchers have found that over years, rather than months, past losers can outperform recent winners. The reversal in Tesla’s stock shows how quickly trends can change.

Still, the trends contain a useful lesson: Investors are often tempted to stick with falling stocks to avoid locking in losses. The better move may be to accept that the pick was bad and move on.

“Generally, laggards don’t improve until their fundamentals improve,” says Morgan Stanley’s Mr. Parker.

In a similar vein, don’t be too quick to sell your winners.

Diversify—a Lot.

Applying these lessons, of course, could expose an investor to the additional risk involved in picking specific stocks. Most people would be better off buying low-cost mutual funds and exchange-traded funds that hold broad baskets of stocks, experts say. And “broad” means hundreds of stocks, not dozens.

Granted, there’s not much fun or sport to that. But there’s little fun or sport to losing money—and picking stocks can easily lead to that outcome, even in a booming market.

Unconvinced? Imagine at the end of 2012 you had $100,000 to invest and decided to spread it evenly across the stocks of dozens of big U.S. companies in many different industries, all from the S&P 500.

You picked a brand-name retailer ( Abercrombie & Fitch ANF -1.94% ), a data-analytics firm that was a large gainer in 2012 ( Teradata TDC +3.72% ), a major Midwestern power company ( FirstEnergy FE -1.49% ) and 42 other companies.

You just happened to choose wrong. You picked the only 45 firms in the index that have thrown off negative total returns for investors in 2013, even after paying dividends. Instead of $100,000, you would have had less than $88,000 through Thursday, according to Morningstar—before deducting any trading fees.

The index investor across the street who instead bought the S&P 500? He would have about $127,000.