The Power Of Hope 092909


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This rally in US stocks appears to us as being powered by hope, rather than fundamentals. How far can it go?

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The Power Of Hope 092909

  1. 1. The Power of Hope Works (…Miracles?) Given all this, we would be all well advised to follow the admonition of Mervyn King. Last month, the governor of the Bank of England stated bluntly: “It’s the level, stupid – it’s not the growth rates, it’s the levels that matter here.” Investors have not yet accepted his insight that the absolute levels of income, debt, wealth and unemployment, not just the rates of change, are what matter today. They need to, and soon. Mohamed El-Erian, CEO, PIMCO (see full Viewpoint at We have been sharing our belief for some time now with clients and readers of our letters that the fundamentals of this stock market simply do not support the levels to which its averages have grown. David Rosenberg, respected chief economist and strategist at Gluskin Sheff & Associates, points out in a recent Financial Times article that the market only became fairly priced when it hit its low point in March of this year. Usually at bear market troughs, he said, the S&P 500 goes to embarrassingly cheap levels. It did not this time. We are now 6 months into a rally that has lifted the S&P by 60% - to a level that is priced for forward-looking GDP growth which is already twice as great as what we can reasonably expect. Price-earnings ratios, a measure of market valuation, increased since March by an unprecedented 8 points. By historic measures of valuation, the market is now about 4 times overvalued. 1
  2. 2. History tells us, per Rosenberg, that total return a year following a run up of this nature turns negative 60% of the time. His conclusion is that there is too much growth and too much risk embedded in the equity market right now. And history confirms this. A Faith-Based Rally? A definition of “miracle” comes to mind. In defiance of the principle of cause and effect, a miracle occurs when an effect manifests that has no discernable cause. We look at the market’s rise since March and we look for a discernable cause. Failing to find a good answer, we ask how long can a market rally be sustained based on the faith that the economy will eventually catch up? It feels to us like this market is being propelled forward by the power of hope. What to Do? We continue to look for signs. Third Quarter earnings reports are coming out in early October. Will Corporate America report real profitability, or will their cost cutting measures and the effect of early government stimulus measures again be responsible for positive results? Currently, we know there is significant liquidity sitting on the sidelines. Some of that money may find its way into the stock market. If economic indicators remain stable, or decline less than they did six months ago, that liquidity could propel the stock market a bit further. We’re all for a continued rise in the stock markets. In fact, there is a case for rising expectations. However, any future optimism on our part toward a sustained market rise rests on seeing more rapid improvement in the underlying economic fundamentals. Give us more objectively quantifiable data before asking us to make any leaps of faith. 2
  3. 3. The new investment opportunities we will be adopting will be based on the amount of risk we believe each one poses in this environment. We may indeed decide to supplement our asset allocations with some stock market exposure and other asset classes that offer a good risk/reward ratio. Whatever equity exposure Silver Oak may decide to take will be well cushioned against extreme volatility with the types of vehicles that have kept our portfolios profitable over the entirety of the last 12 months. We don’t believe in miracles, and our faith in the power of hope is limited. Best personal regards, 3