Bet Against Investor Expectations

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The third quarter closed Wednesday up more than 15%, as economic statistics continue to come in less bad than they were months or quarters ago.  As we have stated in recent postings, stock prices are extremely expensive relative to earnings, dividends, book value or virtually any other commonly employed measure of value.  For stock prices to stay at current levels or to rally further, almost certainly we will soon need to see real growth in reported economic statistics, not just smaller levels of loss.

The remarkable stock market rally from the March lows extended to more than 60% at the September 23 highs without a single correction of even 10%.  Over the past eight market days, however, the market’s tone has changed a bit, as the major averages have fallen by a little over 5%.  Volume, which had been quite lethargic in the latter stages of the advance, increased as the market sold off, adding a note of uncertainty for the bulls.  Where the market goes from here is an open question.

For more than two years the stock market has done its best to confound most investors.  Few anticipated imminent danger in mid-2007 with the Dow Jones Industrials at all-time highs.  Less than two years later, bulls were virtually non-existent after stock prices had declined to less than half of their earlier peak values.  Investors have doubted the sustainability of this year’s rally almost all the way up from the bottom.  Only now that prices have risen 60% have large numbers of investors come to believe that a further rally is likely.  Clearly the path to greatest profits over that span of time was to do the opposite of what felt most comfortable and what most people believed.

On a fundamental basis, the economic outlook is highly uncertain.  As indicated earlier, most economic conditions are getting less bad, but almost none is getting good.  Investors are pricing in a recovery that they expect will get progressively better for a considerable period to come.  At current prices, should future economic statistics or upcoming corporate earnings announcements disappoint, this year’s gains could disappear quickly.  Because the prospect for success of a program of economic progress through unprecedented government stimulus is unknowable, we can’t know what the economic and corporate picture will look like in 2010, much less in years further out.  We are paying historically very high prices for stocks in a remarkably uncertain economic environment.

On a technical basis, conditions look somewhat more favorable.  Whether or not the current pullback ultimately becomes a 10% or larger correction, the odds favor at least one more run toward new market highs for this rally.  Of course, that’s what most investors expect, and the expectations of the majority, as pointed out earlier, have been highly flawed over the past few years.

What surprising market patterns could unfold?  Despite the increase in volume in the current decline, perhaps buyers will resurface next week and the market will proceed even higher, denying latecomers the opportunity to buy into the expected correction.  Alternately, perhaps we have seen the best we are going to see in this rally, and prices may head back to test last March’s lows.  Either scenario would surprise the majority’s expectations, although the latter would be considered a shocker.

We do not have a strong conviction about the market’s near-term direction.  We would add individual equities if we can find some that meet our valuation-based purchase criteria on any further pullback.  On the other hand, with market prices as high as they are, we will not chase equities if we experience no further pullback.  With fundamental conditions as uncertain as they are, we will err on the conservative side until valuations become more attractive.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to or call (520) 529-2900 to speak with one of the Portfolio Coordinators.