Maintaining a high exposure to the stock market has been a winning strategy since March 2009 when the market reached its low following the financial crisis. As a result, investors who opted for a high allocation to stock funds and stock ETFs have made out well. But how much longer is it wise for the average investor to assume allocations at high levels will continue to pay off?

Of course, a parallel question relates to the bond market. In this regard, a high allocation to bonds when considered on a 5 year or even longer-term basis, has proven to be a lower risk, and in some cases, a better performing strategy than investing in many categories of stock funds. And compared to merely investing in CDs or money market funds, bond funds would have proven an elixir, even for conservative investors. But is it now too late to expect further gains, and should bond fund investors instead seriously consider reducing their exposure?

This article will attempt to answer these questions, always bearing in mind that people (even experts) who try to divine these answers are often on the wrong track to begin with. Why? Because how the markets will perform, especially based on short-term considerations, are typically irrelevant for long-term investors and often take your eye off the bigger question: Will you be better off in a year or two (or even more so in 5 or more years) if you simply stick with a strategy of keeping most of your money invested in a diversified portfolio, typically consisting of mainly stocks, a modicum of bonds, and very little cash, than when you are prone to make wholesale moves altering this formula too much.

Stocks

During the last 50+ months post the March 9, 2009 low, stocks have gained about the same amount as during the huge tech bubble that ran from early 1996 to March 2000, that is, in excess of 25% annualized. Of course, that streak ended badly when the bubble subsequently popped. While the same may not happen this time since the current market doesn't appear to be overvalued as the prior period proved to be, the outsized gains should be viewed in historical perspective to see just how far we have come.

Subsequent to its closing low, the return including dividends on the S&P 500 index over the period as of this writing has been a staggering 165%. It turns out that such a gain without the onset of a 20% drop signifying a bear market is among the biggest since 1929, surpassed only by the long-term performance of the late '87 to 2000 market, as well as two periods in the 40's and 50's, and the 5 years that preceded the '87 crash.

Each calendar quarter, my Newsletter issues a new set of allocations to stocks, bonds, and cash along with a Model Portfolio of recommended funds and ETFs. Ever since April 2009, my recommendations have been to continuously raise the allocation made to stocks or at least hold them steady.

While new allocations will not appear until next month, the question that should currently be on many investors minds is this: Given the huge gains described above, is it now the time to suggest that investors should seriously consider cutting back stock allocations that we have continued to recommend at these high levels?

My research suggests, in agreement with quite a few other sources, that most categories of stock funds are not currently near being overvalued, at least not yet. Further, the strong momentum apparently caused by investors now adding to their stock positions tends to create a virtuous cycle. But at a certain point, stocks will start to become overvalued and it may be crucial for investors to recognize when this overvaluation stage is reached.

According to my empirical data, that point might arrive some time this fall, whether stocks continue rising at their current pace or even if they remain near their late-May levels until then. While I will not make a specific prediction that stocks are likely to fall at that time since stocks can stay overvalued for an indefinite amount of time, I will continue to monitor the situation and alert my subscribers if and when any thresholds are reached resulting in SELL signals.

My SELL signals, just like my prior BUY signals (which have been plentiful stretching back to Feb. 2009), are geared for long-term investors. They can't pinpoint exactly when a impending drop will occur, but indicate an expectation, based on my proprietary long-term research, that stocks are unlikely to do particularly well in the forthcoming years ahead. In the meantime, I continue to feel that remaining constant with a stock portfolio allocated similarly to our most recent suggestions made in April is the best course of action.

Bonds

The Barclays U.S. Aggregate Bond Index, consisting of a broad mix of bonds, and which serves as the benchmark for many fund companies bond index funds such as Vanguard Total Bond Market Fund (VBMFX) and the iShares Barclays Aggregate Bond Fund (AGG), has had only two years in which the annual total returns were negative going back to 1976. Over that period, the index has had an average annual return of over 7.5%. No wonder investors have come to assume that investing in many types of bond funds and bond ETFs are close to a guarantee of success.

But during this year's first quarter, the Index actually declined by a small amount. And over the last 12 mos., the 2.0% total return has been much lower than the 7.5% historical average. While the 2% figure is still better than returns for those who remained in money markets or CDs, the question looking ahead is whether returns might wind up negative over the course of the full year, or even over longer periods. This would most likely occur if and when interest rates start rising, either because investors start switching out of their bonds in hopes of joining the stock surge, or the Fed starts sending clearer indications it is about to halt bond purchases (or is closer to the point of actually beginning to raise interest rates).

A Simple Test of Your Bond Fund's Prospects

Down through the years, I have come to put a lot of faith in a simple test of whether bonds look like a good investment ahead. Here it is: Look at how your bond fund has performed over the last one year on morningstar.com. Then look at how it did over the last 3 and 5 years to see if there is a trend over these three figures in one direction or another. A 2 to 4% (or bigger) negative change in the most recent year can be regarded as likely important and suggests the fund may be running out of gas and that you may want to lighten up on it.

For example, the Vanguard Total Bond Market Fund 1, 3, and 5 year past performance results currently show the following total return numbers: 2.0, 4.5, and 5.3%. The trend is clearly for smaller and smaller returns, with the 1 year return substantially below that of the much longer 5 year return, which incidentally includes the 1 year return as a component. This indicates that over a now fairly well-established period of time, investors are getting less and less. In such cases, the odds would appear to favor a continuation of these low returns and also suggest that returns could even be less than 2.0 over the next 12 months if the downward trend continues. Of course, if some now unseen event happens that causes interest rates to drop precipitously such as a major U.S. or even world calamity, or we enter what appears to be a serious period of deflation, investors might rush back to the safety of bonds, perhaps causing returns to rise more than expected.

Contrast these results with the same data for one of my Model Bond Portfolio funds, Loomis Sayles Bond Retail (LSBRX), namely 14.9, 10.8, and 8.1. Not only are the absolute levels higher than for VBMFX, but the current 1 year performance is doing better than its own longer-term results. The fact that the fund is showing an improving trend suggests that the investment is enjoying a relative "sweet spot." The odds would seem to favor a continuation of good performance under such conditions. Of course, at some point, this fund may appear to be on the verge of being overvalued, but I would guess not just yet in light of the fact that its 5 year performance is not even as great as is the case of long-term treasury bonds, in spite of LSBRX being a considerably riskier type of investment than treasuries.

This Simple Test Can Also Be Used With Stock Funds/ETFs

Applying the above method may also be used to judge a stock fund's prospects. For example, to estimate the prospects for a S&P 500 index itself, or a fund or ETF that mirrors it, look at the current 1, 3, and 5 year returns. These are 28.0, 17.4, and 6.1 respectively through May 23rd.

In spite of the big recent run-up, the numbers would appear to reflect a favorable trend that could continue, assuming that the 5 year figure still suggests that the index is not overheated when considered on a longer-term basis. In using this test with stock funds, an approximate 15% (or more) discrepancy between the 1 and 5 year return can be used to argue either for (positive discrepancy) or against (negative discrepancy) the future prospects for the fund. If, however, at some point any fund's long-term performance breaches an annualized 15% or more a year over a 5 year period, it has become overvalued; chances are more than likely that within the next 12 months, it will begin to fall off its perch.

This is exactly what happened by the start of Oct., 2007; overvaluation of almost all categories of stock funds was followed by one of the worst bear markets since the Great Depression. But, to recap, we are not yet in such an over-extended position at present. However, alert investors should keep an eye out for this 15% per year for 5 years demarcation line which my research shows is when the market enters a truly dangerous stage.