Market Outlook: Avoid Overconfidence and Retain a Healthy Respect for Risk

Global stock markets rallied sharply in July - capping the best five-month run in stock prices since 1938 - and have broken out to new bull market highs. Markets have priced in an end to the Great Recession, as evidence of economic stabilization has accumulated.

With the S&P 500 up 50% since the panic lows of early March, the “easy money” in the financial markets has been made, and now it is the trajectory and substance of the economic recovery that will be the greatest determinant of stock market returns. Thanks in large part to the ultra-expansionary fiscal and monetary policies that have been implemented globally, the economy appears set to recover - for awhile. But a self-sustaining recovery needs more than just government stimulus and inventory replenishment; it requires a reinforcing cycle of increasing consumer spending and incomes, and there is no evidence yet of that.

Indeed, U.S. consumers are still reeling from the combination of (1) a doubling of the unemployment rate from 4.8% to 9.5% in just 16 months; and (2) a large negative wealth shock of approximately $15 trillion since early 2007 due to the bear market in housing and financial assets. Moreover, relative to incomes, U.S. household debt levels are still 30% higher than the average levels of the 1990s. The bestcase scenario, as far as the U.S. economy is concerned, is that deleveraging in the household sector plays out over a number of years, with consumers continuing to spend (more modestly) and gradually paying down debt at the same time.

This bull market is only five months old, and should be given the benefit of the doubt, but investors should be mindful that as prices move higher, the risk/reward deteriorates, since price is inversely related to value. It is more likely than not that the stock market still has significant (i.e. 15% to 20%) upside potential over a twelve month time horizon, but that potential now comes with realistic downside risk of similar magnitude. Investors should be especially careful with respect to the timing of any new purchases, given that stocks are stretched to the upside on a short-term basis and are close to a potentially important resistance level of 1000-1025 on the S&P 500.

In addition, the sentiment backdrop has shifted from being a strong positive to a slight negative. Sentiment indicators are not yet flashing serious warning signals, but there are signs of complacency entering the market, which is another reason for caution. According to a composite of indicators tracked by SentimenTrader, a research service that provides comprehensive analysis of investor psychology, 63% of retail investors are now bullish, compared with only 20% at the pessimistic extremes in early March. Similarly, the percentage of bearish respondents in the most recent weekly survey from the American Association of Individual Investors has fallen to 31%, the lowest reading since May 2008.

In this environment, with so many unpredictable forces in play, and with no close historical analogue, no one should be overconfident about anything and investors should retain a healthy respect for risk.

As a result of the strong gains from the early March lows, stocks have moved from very cheap levels five months ago to valuations that seem appropriate (from a longer-term perspective) given the challenging economic environment and the degree of government intervention in the economy and markets.

Investor sentiment has become extremely bullish towards emerging markets stocks, especially in Asia. China is seen as leading the global economic recovery, and Chinese stocks, which are up 90% year to date, have led the global equity rally. Emerging markets stocks, broadly defined by the MSCI EM Index, are now trading higher than their levels just prior to the September 15th collapse of Lehman Brothers. Conversely, the S&P 500 is still 22% below its September 14th closing level. On a price-to-book basis, emerging markets are now trading at a premium to their 15-year average (see chart at bottom, click to enlarge charts).

Broad Stock Market Index Valuation Analysis
Price/Book Value (Net Assets) Multiples 1/1/94 - 7/31/09

Notes:
Blue horizontal lines represent average price-to-book multiples over the period
Red horizontal lines represent 25th and 75th percentile price-to-book multiples over the period

Comments

[vknox:]

Here are some interesting charts from Investors Intelligence.

www.market-harmonics.c...

Seems sentiment is shifting...

Aug 11 02:34 PM