The Risks of the Coming Tax-Cut Stock Rally

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When the latest package of tax cuts gets approved, many expect they will drive the stock market higher. Here's how to avoid getting burned.Experts predict that the soon-to-be-approved extension of the Bush-era tax cuts may drive stock markets higher. But investors beware: As the stock market rises, certain risks will rise along with it.

Many darling stocks, such as Apple (AAPL) and Goldman Sachs (GS), that have already rebounded tremendously from lows in early 2009 may now be reaching lofty heights -- and could become overvalued. Increased market volatility means that any investors caught buying overvalued shares now could see their portfolios devastated if the market suddenly retreats.

Alan Lancz, director of research at LanczGlobal.com and editor of stock newsletter The Lancz Letter, says that if the market rallies on tax-cut euphoria, money managers and other investors may also jump in, driving the market even higher. Lancz, an industry veteran who has produced the newsletter for 20 years, warns investors to keep their emotions in check and adhere to strict investing discipline -- both when buying and selling stocks -- if the market takes off on another big rally.

Reducing Risk

Among the rules that Lancz follows rigorously is to reduce the risk in his portfolio. His firm avoids many hot companies in favor of more underappreciated firms that he feels have fallen through the cracks.

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For example, he bought stocks like Apple and Goldman Sachs two years ago, but has since taken them off his buy list. "There are a lot of higher expectations already in the stock price at these levels and we would rather buy lower-expectation stocks, because with lower expectations, there is lower risk."

Lower-expectation stocks carry lower risk, but have higher potential for gain if they are undervalued. If the next market rally overheats, Lancz says his firm intends to aggressively find such stocks. "We plan to take advantage of that by taking some profits and buying some less-risky securities – thereby controlling the risk levels rather than riding the market's ups and downs."

What kinds of stocks fit his criteria? Some of the recent picks from his newsletter include:
  • Excelon (EXC), the largest U.S. nuclear operator, which pays a 5.5% dividend and is trading near its 52-week lows. Shares closed at $39.46 Tuesday.
  • Pharmaceutical company Merck (MRK), which also offers a dividend and has a pipeline of new drugs -- as well as activities from several recent acquisitions -- that should soon kick in some new revenue for the company. Merck shares are trading below the midpoint of the company's 52-week range, closing at $35.37 Tuesday.
  • Hologic (HOLX), which developed a new 3-D mammogram system that the FDA recently approved for the next stage of testing. The company, which also supplies osteoporosis testing devices and other women's health products, was trading at $17.73 at the market close. The company doesn't pay a dividend, but Lancz considers it a growth stock with great potential. "It is in the early stages of a new product cycle, which should really help its earnings and reputation," he notes. "I think Wall Street will notice that in 2011 and value the stock appropriately."
For the most part, Lancz says investors should focus on finding stocks that deliver a 4.5% to 5.5% dividend, but that also have good long-term appreciation potential and little risk. As the stock market continues to climb, he cautions investors to carefully consider their risk when buying companies at prices that have already grown significantly.

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