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Investors and traders contemplating U.S. equities should analyze both risk and reward. In November, we suggested a four-step approach to this. In summary: look at the worst case situation, a recession, and consider the downside. Then do the same for the upside. To understand this completely, readers (especially those new to "A Dash") should follow the links, which shows supporting evidence for the basic argument.

The Risk

Bearish pundits -- and there are so many of them - have exaggerated the chances of a recession. They have plenty of face time on TV and their websites are the most popular -- so many have been influenced by them. As time goes by, the predictions of a housing or consumer-led recession have been proven false, but many just stretch their tired forecasts further into the future. The indicators they use, like the yield curve, are changing. These indicators are now starting to reflect recent strong economic data. Recession chances have been further reduced, and probably were never more than 25%, only slightly more than the norm. The Fed seems to be hitting the Glide Path, misnomered as a "soft landing." As Dallas Fed President Fisher says, it may not be a landing at all. The best cycle forecasts have come from the ECRI, which is notable (unlike many market theorists) for not generating "false positives." In November the ECRI said "no" to recession and repeated this statement more forcefully on CNBC this week.

Those forecasting recession usually stop with the odds. They discuss the impact in apocalyptic terms, suggesting consequences without specific evidence or quantification. They throw up the fear of 2001. In fact, the 2001 recession caused a decline in forward earnings of about 17%. Even if that unlikely event were to occur now, the market would still be undervalued by about 20% according to the Fed Model. The market has a way of looking through economic weakness.

Recession forecasts have been substantially anticipated by the current market due to the Cycle of Negativity. Many corporate earnings projections have been lowballed by companies because of economic slowdown fears, something they saw on TV or read about in the Wall Street Journal. The earnings downside may be even less given the negativity already reflected in forecasts.

Upside Potential

Wall Street analysts, many fund managers, and most traders are predicting a market increase in line with the projected gain in corporate earnings for the S&P 500. They focus on what we call "local efficiency," assuming that current prices reflect fair value. The problem with this thinking is that earnings have increased by double digits for over three years. While the market has rallied, the recent gains have fallen far short of the earnings growth, while interest rates have remained near historic lows. The spring has been coiled. Alternative investments -- bonds, real estate, and foreign markets -- have all become less attractive after multi-year rallies.

Investors and traders alike should consider the exciting possibility that stocks will come back in line with bonds, a mean reversion proven over time. This would create a gain far exceeding the most bullish Street forecasts. Some cyclical stocks could do even better. They are priced to reflect peak earnings, with analysts forecasting a depressed economy. (More on specific sectors and stocks in future posts).

What if this is the fourth inning of economic expansion instead of the ninth inning?

The sentiment among those currently invested in the market is very negative. This is especially reflected by the extreme views and popularity of bearish market blogs and rookie hedge fund traders, who were schooled by, and are now fixated upon, the 2000 tech bubble. Many of them believe that they learned something, but no one else did. They are fighting the last war, believing that corporate management and analysts are hyping forecasts at a time when they are actually being cautious.

If a market rally gets going, we can expect three things:

1. A buying binge by hedge fund managers, reaching for high-beta stocks and trying to equal market performance;
2. A return to the market by individual investors;
3. An increased commitment by foreign investors to U.S. equities.

A full commitment by individual investors and foreigners, something that may go on for many months, is usually a pre-condition for a market top. Think back to 1999 with Stuart. Compare that blast from the past to what you now see in the ads on CNBC. And 1999 was not even the top.

Catalysts

What would it take to spark a real rally? One can look to the work of Gary Douglas Smith, who writes an excellent daily column for Street Insight, the valuable service for professional investors from theStreet.com. He also writes Between the Hedges, an acclaimed financial blog which we feature as one of our own daily sources.

Gary absolutely nailed the market rally last year. He recognized the pent-up forces of market undervaluation. He had the best read on sentiment. Finally, he made many great trading calls along they way.

TheStreet.com has generously shared his market forecast for the coming year, something that was originally restricted to clients purchasing their professional level of service. Gary has developed a list of 32 (yes, that many!) potential catalysts for a market rally.

Conclusion

Gary Smith suggests that the the S&P will increase by 17%. That is enough to make him more bullish than the average Street analyst, who is constrained by not wanting to go too far from the pack. At "A Dash" we think that Gary's forecast is solid. A well-chosen portfolio could do even better, if the period of Misguided Gloom is finally at an end. Many stocks have (so far) lagged the performance of the price-weighted leaders in the thirty-stock Dow Jones Industrial Average.

While each trader and investor has his or her own risk tolerance, my conversations suggest that most are under-invested in U.S. equities. Those who look at risk/reward, both the magnitude and probabilities, can anticipate the rally right now instead of chasing the performance later.

Source: Investing in 2007: Market Risk/Reward