The Rally Without Respect
Recently, as I meet with investors I have been asked, “Is this rally for real?” In many ways the rally over the last eight months has been phenomenal. As I write, the market has been up nearly 10% over the last 10 trading days—an incredible record given the rally is eight months old and has recorded over 60 percent in gains to this point.
Fortunately, or unfortunately depending on your portfolio profile, the stock market rally is for real and it has several things going for it that can cause it to maintain its current levels.
Generally, as an economy comes out of a recessionary period, the stock market will anticipate the recovery and will start to rally six to nine months ahead of the recovery. Now that this has clearly happened, the economy has started to show signs of life and recovery. These signs have been and will continue to be “I told you so” moments for the stock market bulls. Unless we see signs of the economy weakening again, the recovery is positive for stocks.
Another characteristic of strong bull markets is that nobody believes in the rally and most investors are caught on the sidelines holding cash or other more conservative securities. In the current environment there are a large number of investors representing a large volume of assets that are looking for a pullback in the market so that they can get in. The mere fact that this condition exists will cause the market to be priced above a long term fundamental price until the condition relaxes. The truth is that the market can stay this way for a very long time as investors look for an opportunity to buy in.
As analysts and pundits continue to assert that the rally is not based on any fundamental logic, they assume that the market should always be based on fundamental logic. This is clearly a false assumption.
Historically, the markets have seen long periods of time where market prices and market multiples have only a loose connection to business fundamentals. Because these conditions can exist for such a long period of time, an investor cannot reasonably expect the market to revert to fundamentals anytime soon.
In fact, the mere fact that many investors would like the market to pull back causes the market to go higher. The laws of supply and demand of equity securities dictate that the market will move away from the hopes and expectations of the majority of the participants.
The question investors should be asking now is, “Given that the market has run so far, what should I do now?”
With all this being said, the market is clearly at an above average price and the risk is high relative to expected rates of return. Despite the loose short-term connection between market prices and company fundamentals, the long-term connection will continue and the risk of a significant stock market pull back is real. Investors should consult with their financial advisor and revisit their asset allocation. Making small and steady adjustments is the best way to gain exposure or make adjustments as needed. Investors that choose to be all invested in the market or all out of the market generally take too much risk and live short investment lives.
As we head into the end of the year, investors will continue to bid up prices for stocks. The new year, at some point, will bring an opportunity for the market to re-evaluate the relationship between prices and fundamentals and the loose relationship will, at some point, normalize. The question then will be, "Have corporate and economic fundamentals gained enough to justify the higher market prices?"
0 Comments
Make A Comment