Many years of real-time market experience does not make one clairvoyant, sadly. It can however lend some valuable perspective. Call it realism, call it wisdom; some have it sooner, some come to it later, some just never will.
There is so much excitement today about the momentum in stock prices. Those looking to think clearly must take care. Six months ago our firm were one of few optimists. As markets hit 12 year lows over a 17 month decline, in February-March we were seeing some of the best valuations that we had seen in several years. Not that stocks were “cheap” or high yielding, but relative to several years of uber-expensive, stocks were starting to look relatively attractive.
Fast forward six months and market sentiment has changed 180 degrees. Risk assets around the world are exploding (once again) fuelled with the liquidity of “free” money from government intervention. We can see this pretty much everywhere that we look in the world. The Russian stock market is up 99% year to date, China is up more than 100%. (although these markets are still down heavily from their cycle peak); all dramatic shock and awe. But this is where the plot thickens.
The gains off the March lows have not been fuelled by organic revenue and earnings expansion but rather by an expansion of the multiple buyers are willing to pay for anticipated future earnings. Experience tells us that eventually the present valuation imbalance that we are seeing today will be corrected either by an actual and dramatic increase in corporate revenue and earnings, or by a decrease in stock prices.
Longer term, we see a pick up in revenue albeit at a modest pace as a reasonable probability. But in the more immediate term we measure that stocks today are over-bought and over-priced. Sentiment has gone from depressed to manic euphoria in a matter of 6 months. This is not typically the way lasting bull cycles begin. Real economic recoveries begin gradually and build over time with the stock market climbing a wall or worry as it goes.
An unapologetic market bear, David Rosenberg writes today:
“MR. MARKET IS ON STEROIDS
Not much more to say. The S&P 500 is now up more than 60% from the lows, which is truly amazing and kudos to those who called it. But the question is whether the fundamentals will ever catch up to this level of valuation — usually after a 60% rally, we are fully entrenched in the next business cycle. Never before have we seen the stock market rise so much off a low over such a short time period, and usually at this state, the economy has already created over one million new jobs — during this extremely flashy move, the U.S. has shed 2.5 million jobs (as may as were lost in the entire 2001 recession).”
In short, market gains in the past few months are surreal. As much as we would love to believe that this is the next cyclical market recovery underway, everything that has happened so far has the classic hallmarks of a big bear market bounce in an ongoing secular bear. Each day that this “incredible rally” goes on, the risk to the downside gets more ominous. We have gone back through every market recovery in the past 100 years and could find no period where the parabolic spike matched that of the past few months. This time could be different. Maybe earnings will pick up dramatically and these gains will stick– that is the best case scenario. But the risks of downside scenarios are mounting at this point. Voicing caution about price risk at present levels is once again the exception rather than the norm.
Art Cashin, a 50-year market commentator recently expressed his ongoing concern on CNBC this way:
Starting in October the US Federal Reserve and many other countries are expected to wind down their aggressive monetary intervention. At the same time, the Obama Administration has recently said that it is looking more broadly at getting out of the bailout programs used to prop up the financial system after its 2008 collapse. Makes sense: if the economy is truly in recovery now, the government should back out. The question that remains very much unanswered though is what or who will take its place? Cars? Post cash-for-clunkers, September sales have virtually vanished. Housing? The more they build now, the more they are piling on to the already mamoth inventory hang-over. Financial innovation to increase leverage? Not likely; at least for some time.
In the end, the market serves to crush the greatest number of speculative spirits. If it has correctly priced the start of the coming economic recovery then the recovery is expected to be very strong and lasting. If that is the case, stocks will continue to rally for many months and likely years from here affording lots of opportunity to become fully invested. If the stock market has now over-priced the recovery, then near-term price risk must be high at this point. In either case, rushing heavily into stocks here is more about specultation than investing, more likely to be fool than wise.
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