Despite a more than 50% stock market gain from the March 6, 2009 lows, the S&P 500 is still down by about 20% from late August 2008. A rally of that size in approximately five and one-half months is not unprecedented, but it is rare. That such an advance should persist without even a single pullback of 10% makes it even more uncommon. Because the investment industry has become so short-term oriented, the rally has put tremendous pressure on investment managers whose performance is carefully scrutinized at least quarterly. Even those who dislike the fundamental picture are feeling great urgency to add to their equity exposure. Bonuses — even their jobs — may be on the line for managers who underperform their benchmarks in 2009 after having lost money for clients in 2008.
On a fundamental basis, it is clear that U.S. corporate and personal balance sheets have suffered a terrible hit. With unemployment still increasing, the consumer remains under tremendous pressure. Over the past several weeks, however, we have heard repeatedly of “green shoots” suggesting the recession’s end is near. This lends great hope to those who would build a fundamental case for a lasting bull market for stocks.
The technical side of the ledger looks more compelling than does the fundamental. Despite the rally’s scope and duration to date, most technical measures indicate the likelihood of at least somewhat higher prices. The majority of momentum measures are weakening, however, suggesting at least a correction in the not-too-distant future.
In our Second Quarter Commentary (see Prior Quarterly Commentaries) we pointed out that rallies can take on lives of their own and are capable of lasting as long as investor enthusiasm can be sustained. While short covering has been a major ingredient in the rally thus far, each market advance feeds on the additional short covering it promotes. To a point, this is a positive feedback loop, but all such loops exhaust themselves eventually.
Whether or not the market moves higher without at least a meaningful correction, purchasing significant amounts of stock near these levels involves a large degree of speculation. Most measures of valuation are selling above their long-term norms according to Standard & Poors. Because of massive writeoffs over the past year, the price-to-earnings ratio of S&P’s “as reported” earnings is well above 100, a wildly unprecedented level. Following the first quarter of 2010, should S&P’s earnings estimates prove to be accurate, the PE ratio for the S&P 500 will still be over 26 times earnings. Even operating earnings (everything but the bad stuff) show a trailing twelve months PE ratio of 40 today and an above average 17 projected after the March quarter 2010. That’s extremely expensive, particularly in an environment in which the predictability of corporate earnings is highly suspect. Not surprisingly, our investment approach, which seeks only attractively valued stocks with growing earnings, is finding few qualifying candidates at current prices.
Obviously the massive stimulus amounts that have been dumped into world economies have contributed tremendously to the rising levels of world stock prices. What we cannot know today is whether or not improvements in the world’s economies and markets will rekindle the enthusiastic spirit of consumption that has fueled the economic growth of the past two decades. Bulls are counting on a return to our deeply engrained borrow and spend patterns. Bears contend that widespread unemployment and the damage done to consumer balance sheets will alter saving and spending patterns for a generation. The outcome is pure speculation.
Other questions beg to be answered as well. Are global economies and markets performing so well simply because they have been juiced by government induced steroids? Will the effects disappear as soon as the stimulus is withdrawn? Will rescues of major banks and other financial institutions have lasting effects, or will underlying fragility reassert itself once government crutches are removed? Is it possible that world governments and central banks can simply print us out of catastrophe and into prosperity? Or will there be an inevitable day of reckoning? We will explore these and many other questions in future postings.
In conclusion, market prices could certainly continue higher from here. Such an outcome would constitute either successful speculation on market dynamics or a successful resolution of the above-mentioned open questions, answers to which are simply unknowable today. A bet on the positive outcome, however, also introduces risk of potentially substantial loss should some of these questions be resolved negatively.
Those seeking more traditionally defined investment opportunities may want to be more protective of capital in these highly uncertain conditions. Stocks are not cheap, and the current huge advance is essentially uncorrected. It is probable that more attractive buying opportunities will emerge within the next several months, even if markets should head higher first.
Click here to see how Mission’s Controlled-Risk Flexible Allocation portfolios performed through this extremely dangerous decade. Our strong performance results from a combination of flexible asset allocation as well as a willingness to remain patient when stocks are overvalued and other investors overly enthusiastic.
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 Tom@missiontrust.com or call (520) 529-2900 to speak with one of the Portfolio Coordinators.