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I attended the funeral of a friend last week . At the reception afterward a newly-made acquaintance asked whether I thought the rising stock market made any sense in light of peripheral European countries wrestling with default, the earthquake, tsunami and threatened nuclear meltdown in Japan and numerous Middle Eastern and North African nations in revolt. It’s a question being asked consistently on financial news stations, in the press and on the cocktail circuit. His follow-up question was whether he should remain in a highly risk-averse position, which he adopted when the bad news hit, or whether he should reestablish equity positions and take a chance that stocks will continue their upward climb in the face of news that would normally push prices down.

While it did not fit the questioner’s actual situation, his questions reminded me of the old adage that the market can remain irrational longer than you can stay solvent. In other words, from time to time the market can and will do the improbable – even the irrational – far longer than people anticipate. This puts a premium on risk control. In the current situation, the long list of negatives is countered by world monetary authorities flooding economies with liquidity. So far, that liquidity as well as investor confidence that it will continue has trumped all the negatives. It is conceivable that the Federal Reserve and other world central banks will succeed in re-energizing the global economy without kindling destructive inflationary fires. That beneficent outcome, however, is not the norm when governments try to bail out economies after banking crises. Almost universally, as pointed out in copious detail in "This Time Is Different," by Reinhart and Rogoff, economies struggle for several years before returning to some semblance of normalcy.

Owners of equities today should evaluate the landscape carefully. The major stock indexes have doubled in price over the past two years but still are at prices first reached in 1999, the start of the decade of no return. While the economy has grown vigorously off the recession’s severely depressed trough, most economic measures are still at levels typical of weak, not strong economies. Corporate profits have surged higher, but ratios of valuation such as price-to-earnings, dividends, book value, sales and cash flow are all above historical norms. In fact, all but price-to-earnings are at or near all-time highs but for the recent bubble years that produced essentially no stock market return. On a historical basis, stocks are extremely expensive.

Equity buyers today will profit only if the Fed’s liquidity flood succeeds in overcoming the long list of negatives, and if this time truly is different and the economy and markets don’t suffer their normal fate following banking crises. Alternately, the successful trader can make money if the market continues higher, and that trader is astute enough to recognize telling signs of the ultimate market top. Unfortunately, nobody rings a bell at such tops. Few traders successfully lightened their equity positions before the disastrous market declines that began in 2000 and 2007. Compounding the danger today is the near-unanimity of bullish conviction. As a result, equity allocations are near their upper limits. The exit doors are not very wide if many decide to leave at the same time. With the flash-crash peril of last May still fresh in our minds, the danger of a repetition creates the potential for a large gap down, should something shake investors’ confidence suddenly.

We have chosen to remain highly risk-averse until we find more stocks at historically attractive levels of valuation. This approach is especially important for any investors with largely irreplaceable capital.

Source: Does the Stock Market Rally Make Sense? Staying Risk Averse Does