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When to Taper Your Exposure To U.S. Stock ETFs

Stocks in this article: SPY ITB XHB EPI IEF

NEW YORK (ETF Expert) -- Long-time readers and clients already know how I feel about the current U.S. stock market bull. For example, the absence of revenue growth at corporations (e.g., average sales growth for Dow components in 2013 is -0.7%) and the exceptionally high cyclically-adjusted P/E (i.e., 25) do not matter right now. And that's okay.

Pending home sales have dropped for five straight months and mortgage applications have declined for five consecutive weeks, placing a potential damper on the real estate recovery. That's okay, too. Not to be outdone, bearish sentiment by investment advisers, a well-tracked contrarian indicator, has plunged to its lowest level in a quarter century (14.3%). That's fine as well.

In other words, as long as the investment community believes Federal Reserve maneuvers will benefit equity risk-taking, it is sensible to participate in the easy-to-identify uptrends.

On the other hand, let me present a hypothetical scenario whereby the Dow at 16,000 rises to 20,000 over the next 12-24 months. Should the 25% price gains occur, even the most strident bulls would recognize the historical probability of a stock bear emerging after six to seven years of upward movement. It follows that those 25% gains would be wiped out in a buy-n-holders account if a 20% bear came to the picnic table. Moreover, with the average bearish erosion at 30%, a Dow Industrials stock that reaches 20,000 might see 14,000 before it sees 24,000.

The point here is not to discourage advocates of exchange-traded funds from participating in the Fed-fueled rally. Rather, the point is to drill home the notion that, at this point in the cycle, you cannot afford to buy-n-hold your stock assets.

Fortunately, there are a number of simple ways to determine whether it is time to lighten up. One of the most basic methods? Bolster your cash account if the price of the SPDR S&P 500 Trust (SPY) breaches its 200-day on the downside and fails to bounce back quickly. You could sell a small portion, a large portion or the whole kit-n-kaboodle. Just be certain to be consistent with your personal discipline for reducing risk.

Decisions based solely on trendlines are far from perfect. Nevertheless, they'd have helped you avoid the bulk of the 2000-2002 bear, the panicky portion of the 2008-2009 collapse as well as provide a measure of comfort during the extreme price swings in the 2011 eurozone crisis.

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