Yearly Archives: 2009

Too Much of a Good Thing?

This week the Wall Street Journal ran an interesting story entitled, “What Are You Paying For?”  The gist of the article was that many fund managers invest in so many stocks that their funds begin to look like the market.  The author’s criticism centered on the fact that these managers are charging higher fees for services and performance that could be obtained via an index fund. He said, “’Closet index funds’ have higher fees than true index funds but don’t differ enough to justify the higher costs.”

I am not one to criticize any fund manager – I think their jobs are challenging enough without any kind of grief from me.  If a fund manager can produce consistent above-market returns, I could care less how many stocks are in the portfolio.

But this article did get me thinking about the concept of diversification and made me wonder if one can have too much of it.  Everyone knows the idea of diversification from the old saying “Don’t put all your eggs in one basket.”  Investors should invest in a number of different stocks and asset types.  But how many is enough and how many is too many?

We can attempt to answer this question intuitively.  Everyone would agree that owning just one stock would be the riskiest investment possible.  We can also agree that adding one more stock would reduce the risk a bit.  As would the third, fourth, and so on.  Reducing risk by adding another stock to the pot happens due to something called “correlation.”  Because the price of a given stock is governed by its own fundamentals and investor perception of those fundamentals, it tends to move in a somewhat different pattern than other stocks.  To the extent that two stocks tend to move differently from each other (that is, their correlation with each other is low), holding them both in a portfolio will reduce risk.  Obviously, owning 10 energy stocks (whose correlation with each other will be high) will be more risky than owning 10 stocks from different sectors.

Aside: This may be a good time to talk a bit about risk.  Risk is not the same as losing money in your investments.  Risk, as most professional investors measure it, is the price volatility of the asset in question.  One stock would have the most price volatility imaginable (up or down), and this volatility is reduced as we put more stocks into the portfolio.

The problem with an intuitive solution to this question is that it seems that a portfolio of 100 stocks would be 10 times less risky than a portfolio of 10 stocks.  And a 1000-stock portfolio would be even better – that is, more diversified.  The real solution is mathematical.  The relationship between the number of stocks in a portfolio and its risk is not linear, it’s exponential.  So at some point the addition of another stock to portfolio will reduce the risk only a very small amount.  The chart below illustrates this.

DiversificationSource: Investopedia

So mathematically speaking, 20 seems to be a good number for optimal diversification.  The problem here is that 20 names will rarely provide the industry sector diversification one may want.  Although the “right” number remains a point of discussion, many fund managers who like to keep the stock count low will agree that something around 30 is a good number.

This has been the guiding principle for diversification my entire career.  While I was thinking about this issue, I did a quick check on my personal portfolio.  Sure enough – it has 28 names in it.  Just about where diversification feels “right” to me.

Much of the commentary out there seems to suggest that many individual investors have too few stocks in their portfolios.  Often these “portfolios” are just a numbers of stocks the individual selected or was recommended by interested parties.  A “real” portfolio, in my opinion, is one which contains enough stocks in different sectors to allow the magic of diversification work.  Investors should also avoid the temptation to own 100 (or some other large number) stocks simply for diversification reasons.  Like many things in life, moderation seems to be the answer to how many stocks truly make one’s portfolio diversified.

What About Bonds?

Recently I came across a news item that caught my fancy:

“Corporate bond sales hit record. Corporate bond sales surged to a record annual high of $1.171T YTD – more than the $1.167T sold in all of 2007 – as companies take advantage of low interest rates to rebuild their balance sheets. Companies that could not sell debt during the financial crisis are borrowing more aggressively, and being careful to sell debt with longer maturities to avoid being trapped by refinancing risk as they were in 2008, analysts said. The bond sale surge was also supported by the FDIC’s debt-guarantee program – companies issued $200B of debt guaranteed by the FDIC this year before the program ended on Oct. 31.”

The rationale for companies issuing a record amount of bonds this year makes total sense to me – take advantage of the current low interest rates.  But if interest rates are going to rise in the future (it must be true – “everyone” says it going to happen…), why would investors want to buy this record level of bonds at these unusually low rates? Is a puzzlement…

I’ll be the first to admit that I am not an expert on bonds.  Most of my career has focused on the equity market.  To me, the formula for bond investing always seemed a bit simplistic – interest rates up, prices down, and visa versa.  Clearly this view grossly understates the complexity of the marketplace, but it is where I begin with bonds. Fortunately, I know a lot of very smart people who are very good at bonds.

So, I turned to some of my smart friends to answer the puzzling question above.  Through these discussions I learned a number of important things about the world in general and the bond market in specific.

  1. The World is a Safer Place Now. With both the credit crisis and recession fading into the past, investors are once again comfortable with owning assets other than cash.  Stocks still may be viewed with some skepticism, but bonds yielding 2-4% are much more attractive than cash yields near zero.  So part of the enthusiasm for bonds is an asset allocation shift from cash to bonds.
  2. Stimulus Money Needs a Home. The $3-4 trillion (more or less) in government stimulus money already spent needs to go somewhere.  We have seen the impact of all this liquidity in lots of places – commodities, oil, gold, stocks and bonds. Given the huge size of the bond market, it would not be surprising that it received a majority of this cash injection.  Oh, and the bulk of the approved stimulus spending is yet to come.
  3. Inflation vs. Deflation Debate Good for Bonds. Although many expect inflation to eventually pick up sometime in the future, some of the credible bond market commentators are still warning about the threat of deflation.  Deflation is especially pernicious because it’s so hard to fix (consider Japan’s 20-year fight with it) once it takes hold.  Whether or not deflation becomes a problem, the fact that it’s still being mentioned as a threat gives many bondholders comfort that inflation will not be a problem in the near to medium term and that interest rates may remain stable for longer than most expect.
  4. Low Interest Rates Benefit Many “Important” Groups. The aggressive monetary easing we are currently experiencing benefits a large portion of the economy, but especially the auto industry, the housing market, the banking industry (have you seen bank profits lately?), and other stressed groups.  Thus, bankers, politicians, unions, and lots of other highly-visible groups really, really like the status quo.  At some point, the Fed may see the need to raise rates, but we can image that Mr. Bernanke is being bombarded by many voices urging him to wait as long as he can.  This delay would be good for bond investors as well as these other groups.
  5. The Futures Market is Calm. Although not an exact guide for what may happen in the future, the Fed Funds Futures market can give us a clue what investors are expecting from short-term rates down the road.  Right now this market is looking at a 1.35% Fed Funds rate by the middle of 2011.  This too argues that few expect any kind of aggressive tightening of monetary policy within the next 18 months.

So, what’s not to like about bonds?  Well, low yield for one.  Is the 10-year US Treasury bond a steal at 3.4%?  We are still seeing some deals in the corporate arena, but for the most part bonds look like “everyone” already loves them.  Does this make me bearish on bonds?  Not really.  I can also see the logic of owning them versus cash.

I guess my view on bonds is mixed, but the current enthusiasm for bonds does, at the margin, make me a little more bullish on stocks.  Why so?  The investors who were able to leave the perceived safety of cash for a little more yield in bonds will eventually find bond returns unacceptably low and turn to stocks.  The fact that this hasn’t happened yet gives me comfort that the new bull market has room yet to run.

Gratitude – 2009 Edition

It may seem a bit cliché to list the things for which I am thankful at this time of year, but Thanksgiving is such a wonderful holiday exactly because it offers us a chance to reflect on the good things in our lives.  Thanksgiving is also the last major U.S. holiday that has yet to succumb to consumerism (some may argue this point given its proximity to “Black Friday” and the consumer feeding frenzy it has become, but I would submit that “Black Friday” has nothing to do with the Thanksgiving holiday itself.  So there!)

So without further ado (and apologies to David Letterman), here are my top ten reasons to be thankful this year:

10. The New Bull Market. Many still cling to the fantasy that a 60%+ market move can be nothing but a bear market rally.  I believe they are wrong.  This new bull market began exactly where one would expect it (in the middle of the recession and at the peak of pessimism) and has climbed the proverbial wall of worry as economic data throughout most of the March to July period continued to show weakness.

9. Low Interest Rates. Not only do they help certain troubled industries (autos, housing, banks, etc.), but they are forcing investors to seek assets which can provide higher returns – like stocks…

8. Tons of Cash on the Sidelines. Many investors still fear the stock market.  Even after this huge rally and the beginning of a new bull market, many folks still hold a huge amount of their wealth in cash or money market funds earning less than 1%.  I view this as dry wood which will eventually be used as fuel to propel the market even higher.

7. Mixed Investor Sentiment. Some people are calling for a “double dip” for the economy.  Some still think that testing the March lows is a possibility.  Some think gold is the only “safe” asset.  Some are seeing new bubbles around every corner.  Some think the government is somehow propping up the markets.  What a fine, grand debate we have here!  The minority opinion still seems to be that stocks can move higher from here.  I guess I’ll have to side with the minority opinion (yet again…)

6. Graham & Dodd. The “fathers” of value investing gave me and others the tools to analyze stocks in our search for excessive returns.  Their work represents the foundation of my career and investment philosophy.  Their work has enabled me to spend my research efforts on measuring and not predicting.

5. Value Investors. The “children” of Graham and Dodd, such as Warren Buffet, John Neff, Christopher Browne, John Templeton, Marty Whitman, Bruce Berkowitz, etc., have provided me excellent role models, showing me that this value investing approach is workable and can be successful.

4. Jim Cramer and CNBC. As long as the media feels the need to provide us with an endless stream of “free” investment advice, I feel that my voice, which I hope is a voice of reason, needs to be heard.

3. The First Amendment. I’m thankful for a country which allows my voice to be heard.

2. Thomas Jefferson. Still my favorite founding father and a major inspiration to me.  “If we can prevent the government from wasting the labors of the people, under the pretense of taking care of them, they must become happy.”  Letter to Thomas Cooper (1802).

1. Opposable Thumbs. Most excellent for holding my grandsons, tossing the football at our annual “Turkey Bowl” and, of course, grasping that big drumstick at the big meal tomorrow surrounded by family and friends.

Thumb

Bubble, Schmubble…

Bubble, Schmubble

Bubble, Schmubble

Here we are just 8 months from the stock market’s bottom, a bottom, mind you, that was created by a massive credit crunch and the worst recession in decades, and already we are hearing talk that another bubble may be forming.  Some “experts” are trying to warn us that the government’s easy monetary policy and/or fiscal stimulus will be enough to drive the prices of some “stuff” (gold, commodities, stocks, houses, whatever, etc.) to new bubble levels.  First of all, we still struggle with the definition of a bubble.  It seems to me that we can only truly define a bubble after it has burst.  In the middle of the 1990s Tech Bubble, many were calling it a “bull market,” a “paradigm shift” or the “next big thing,” and not a bubble.  The tech executives, who became billionaires on the back of that bubble, would probably conclude that bubbles are not universally bad.  Some think that all of the world’s economic problems are due to the latest bubble.  I would consider this a topic worthy of a healthy debate.  Others think that new rules are needed to prevent the next bubble.  I would note that the financial services industry is one of the most highly regulated industries out there.  Also, to my knowledge no one has been convicted for breaking any laws in regard to this crisis.

Second, bubbles may be the natural result of rational people searching for irrational returns.  When a person could buy a house for no money down and no credit check and then turn around and sell it within six months for a $50,000 profit, why not do it?  There may have been warning voices at that time of potential negative consequences, but the allure of quick profits is simply too powerful to resist for some folks.  The same thing happened with amateur day traders in the late 1990s.  This part of human behavior has been observed over and over again at least from the South Sea Bubble in 1719.  As long as investors have the opportunity to place their money at risk for the possibility of reward, excesses, or bubbles if you must, are likely to occur.  Charles Kindleberger, in his excellent book, Manias, Panics and Crashes, agrees – “Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common.”

Third, much of the bubble talk heard these days appears to be centered on one of my big pet peeves – the ceteris paribus (all else held constant) argument.  This line of reasoning goes something like this – “If the current trend (weak dollar, loose monetary policy, rising stock prices, whatever) continues without changing (this is the ceteris paribus part), bad things will happen.”  This argument is cheap and easy to use (probably why we see so much of it in the media) and it has a certain amount of appeal to it.  It’s almost always hard to disagree with the conclusion and it usually seems to make sense.  The fact that things always change rarely surfaces when the ceteris paribus guys are around.  Things always change.  Supply will increase to meet more demand.  Higher prices will eventually lead to lower incremental demand.  Occasionally, a black swan flies in to change all expectations and assumptions.

It seems wise to keep a vigilant eye on the signs and evidence of bubbles, but from my vantage point, I see nothing bubbly about the stock market right now.  Valuations are reasonable, money on the sidelines is plentiful, sentiment is still mixed and earnings are still growing.  Sounds like a recipe for anything but trouble.

“Double, double toil and trouble; Fire burn, and caldron bubble.”

– The Witches from Shakespeare’s Macbeth

We Salute You!

On this day of honor and reflection, I wish to pause and add my thanks to the millions of brave men and women who have served and are now serving our country in the military.  I grew up during the Vietnam War, a period of US history where feelings about the military and war where very confused.  However, to the members of the “Greatest Generation” in my family, military service was considered an unequivocal privilege and an honor.  Four of my uncles are veterans.  My mother served in the Women’s Army Corps (WAC) during the Korean War, and my aunt Lilah was a career WAC.  Those of us who have never personally faced the horrors of war can only stand in awe of those who had the fortitude and courage to serve this way.  We salute you!

“History does not long entrust the care of freedom to the weak or the timid.”

— Dwight D. Eisenhower

What is Normal?

During the last year we have seen some spectacular (and rare) events. From the credit crisis last Fall which generated enough serious concern to compel the US government to “bail out” a number of large companies, to the nearly-unprecedented rally in the stock market from March, these are strange days, indeed. The biggest problem with these unusual times (aside from losing money, of course) is that they tend to skew our perception of what is normal or usual. In less volatile times, most of us have a clear idea of where the borders of normalcy lie. Occasionally, something happens that makes us think, “Hmm, now that’s unusual,” but most days, time marches on in a steady and familiar beat.

In more volatile times, we tend to assume that anything can happen, no matter how low the chances really are. “If Lehman Brothers can fail,” we muse, “why not ALL the investment banks?” “If AIG can be driven to the brink, why not ALL insurance companies?” “If stocks can fall 40%, why not 100%?” Whereas before one “black swan” would have evoked appreciative “oohs” and “ahhs” of wonderment at its rarity, we now expect flocks of them descending into our turbulent ponds. Much of the commentary I see continues to suggest that the events of the last 12 months are the “new normal.” Some experts still call for stocks to revisit the March lows. Others think that the economy will sink back into recession. Still others predict that the US dollar will continue to fall due to the US government’s massive budget deficit or a permanent lack of confidence that the US economy can ever again maintain sustainable growth. To all this, I say “poppycock.”

I still believe that the four most dangerous words in the investment parlance are “this time is different.” Investing is an exercise in probabilities, and those who are always counting on a highly unlikely outcome generally perform a lot worse than those who operate within the bounds of normal distributions. Let’s take a look at the US dollar for an example of this. The chart below shows the S&P 500 compared to the US dollar over the last few years.

S&P 500 vs. Barclays US Dollar Index

In normal times, we expect the dollar and the stock market to move together – what’s good for stocks is generally good for the currency. This is the normal relationship. As seen in this chart, when the crisis hit last year the dollar became a “safe haven” currency and appreciated vis-à-vis other currencies, and at the same time stock prices fell. In March, the spread between the dollar and the S&P 500 peaked. At this point, anyone who thought that the “normal” relationship between the US dollar and the stock market should return would have shorted the US dollar and bought stocks. The chart shows that since March, indeed the US dollar has weakened and the stock market has risen. The purported reasons for these moves are legion in number, but most commentators will talk about the big, macro factors. Smaller factors like simple reversion to the mean, in other words, returning to normal, seem to be too insignificant to be real. I wonder.

So what do I think “normal” is right now? First, the economy is recovering in a fairly normal fashion from its recessionary trough. The pace may be below past recoveries, but many of usual elements of the recovery are there. The stock market is also responding in a normal fashion to the key drivers of performance – earnings, interest rates and sentiment. The media is also acting as one would suspect – searching out the most sensational stories or highlighting those experts with the most extreme opinions. After all, “normal” is not newsworthy. Finally, I think that many retail investors are acting in line with expectations. Some of them sold near the bottom and continue to hold cash ($4 trillion is still sitting in money market funds), waiting for the “all clear” signal from someone they can trust.

In a “normal” bull market, we should expect stock prices to rise over time with the occasional correction of 10% or so. The next time stocks begin to look a bit weak, we should try to avoid the natural tendency to think that they are somehow destined to go back down to the March lows, and simply accept the correction as a normal part of this new bull market.

It’s Not That Random

I am continually amazed that some people still look at investing as a random walk.  Perhaps this idea stems from the lingering effects of Burton Malkiel’s 1973 book “A Random Walk Down Wall Street.”  Professor Malkeil’s thesis centers on the difficulty of “beating” the market.  He shows that investors who use either technical or fundamental analysis will generally do no better than ones who employ a passive (i.e. index funds) strategy.  His work and all that followed it seem to hold up pretty well when considering the “average” investor and all investors taken as a whole.  In aggregate, investors may not beat the market over time, but that does not mean that every investor fails to beat the market.  His work cannot account for great investors such as Warren Buffett, Peter Lynch, John Neff, George Soros, Julian Robertson, Bill Miller and so on.  It also fails to explain why billions of dollars in hedge funds continue to perform better than the market year after year.

I think some people must find comfort in the idea that investing is random.  Often it appears to be random.  We all have heard stories about somebody’s brother-in-law or cousin once buying a stock and seeing it go up 100% (or whatever).  Often the beneficiaries of this good luck have limited experience with the markets and no formal training.  Thus, this twisted logic goes, if this person can make money in the market, it must not be that hard or it must be random.

From this point of view, it’s very easy to conclude that investment is akin to gambling.  You place your bet (buy a stock, for example), roll the wheel (wait a while) and then either collect your winnings (the stock goes up) or mourn your losses (it goes down).  The idea that there might be a way to remove some randomness from this exercise probably never crosses the gambler’s mind.

Professional investors have many tools available to them, which may be generally out of reach to the individual investor.  Let me briefly suggest four of them which I consider important.  First is time.  Someone who is looking at the market every day as a full-time job is very likely to do better than someone simply doing it as a hobby.

Second is information.  Although the average investor has good access to public documents such as annual reports, their potential information flow is only a trickle compared to that from which the professionals drink each day.  From expensive databases to daily market intelligence from professional prop traders; from direct communication with CEOs to the ubiquitous Bloomberg terminal; from company visits to complicated computer algorithms, the professional has a much better information flow to aid in making decisions.  I’m not talking about “insider information,” the use of which is illegal, but just better and/or more information.  Better information often leads to better decisions.

Third is training.  One does not need a degree in finance, accounting nor the CFA (Chartered Financial Analyst) designation to be a good investor, but it surely helps.  In my view, the better one understands statistics, calculus, economics, accounting, probabilities, corporate finance, monetary policy, taxation, valuation measures, human nature and the laws of physics, the better investor one could be.  Simply buying a stock based on one “high concept” idea (renewable energy, for example), is a recipe for doing no better than the proverbial random walk.

Fourth is experience.  Pattern recognition is an important component of investing, and those who have been through a number of investment cycles (bear and bull markets) are more likely to make good decisions at crucial times, exactly because they have “seen this before.”  I’d be the first to admit that I had many white-knuckle days during the last year, but despite all of the uncertainty and dire pronouncements that “this time is different,” I could draw some comfort from the fact that I had seen similar levels of fear before – both in 1987 and 2000.  These experiences helped to guide me through the worst of the bear market and to prepare me for the next phase of the investment cycle (the new bull market).

I am not suggesting that investing is easy.  It is a very challenging exercise, one that is very different than gambling.  The professional investor has tools that can skew the odds of success in his or her favor.  For those of us who have chosen this path, it can also be a very satisfying and rewarding exercise.

It’s Just a Number

Here it comes – another grumpy post…

Sure, I’m as happy as anyone that the Dow Jones Industrial Average (DJIA) has once again breached the 10,000 level. Yet all this attention over the attainment of one particular level – we sure love big, round numbers, don’t we? – is, in my view, really beside the point. The fact that the 10,000 level is big news is just another sign that a large percentage of the population looks at the stock market as one thing – the DJIA. These reports fail to note that the DJIA is comprised of only 30 stocks, 30 big stocks. Until recently, it contained former “blue chip” names such as Citigroup (C) and General Motors. Most of the Dow companies are “American” only in that their headquarters are located in the United States. A huge portion of these companies’ revenues and profits come from operations outside this country. Most of them are experiencing solid growth in China, Brazil and other so-called emerging economies. My point is that the DJIA represents just an abstract number, a data point which actually represents the aggregate opinions of thousands of investors regarding each company – its valuation and future prospects.

For me, the bigger celebration should have been August 3rd of this year, when the S&P 500 broke through the 1,000 level, which in addition to being a nice, round number, was an important resistance level, and is now a key support level. Most people who invest in stocks don’t just buy “the market;” they buy Raytheon (RTN), Agrium (AGU), OM Group (OMG), or whatever. The concept of the market being just one thing, one number, probably increases the common misconception that investing is akin to gambling. The market goes up; it goes down. It may seem quite random to many people. This is unfortunate.

Stock prices are higher than they used to be because interest rates are low, earnings are growing and skepticism is still high. These are not random forces – they are powerful, sustaining and sustainable forces. The Fed wants to maintain low interest rates to aid many industries, including autos, finance and housing. Earnings have been growing due to aggressive cost cutting from the early days of the recession and a resumption of spending. Skepticism and cash levels are high because investors have been dealt a gut punch, which may take a while to get over. Oh, and by the way, many of the “gurus” on television told them to sell stocks and hold cash earlier in the year.

Many of the articles “celebrating” the 10,000 level were replete with warnings from traders and strategists suggesting that the party can’t last and that “the market” is ripe for a fall. In my view, this is the real reason to celebrate this level – people are still very worried about a lot of stuff. This concern, this worry will keep sentiment from becoming overly bullish. Overly bullish sentiment is one of the things I really get worried about.

The typical bull market lasts about 4 years and can propel “the market” to a multiple of its bear market trough. For me to predict that we could see Dow 20,000 by 2013 would break all three of my rules of making predictions: 1) if you predict level, don’t predict timeframe, 2) if you predict timeframe, don’t predict level and 3) I don’t make predictions. Yet, if this bull market turns out to be normal, 20,000 by 2013 would not be unexpected. Remember folks, you heard it here first…

Where’s the Love?

One sign that we are in a new bull market, in my opinion, is how excited everyone seems to get whenever the market goes down a bit (like it did on October 1st) or when a bit of disappointing economic news is released (like today’s employment report).  It is as if people don’t really believe that the stock market rally, which started in March, is real.  This has led to an uncomfortable feeling by many investors that hovers awkwardly over the triangle whose corners are marked by “fear”, “hope” and “despair.”  Because of the massive hit investor wealth has experienced (although we would note that the market is only down 8% from this time last year!), investors fear that all the recent gains could be somehow wiped out in an instance.  They hope things will get better, but so much of the commentary aired in the media focuses on huge, potentially negative imponderables such as the U.S. government budget deficit, the weak U.S. dollar, inflation, etc., that this hope easy turns to despair whenever we hit a patch of bad news.

To me, this bruised and confused investor psyche is actually a positive thing.  It suggests that investors have learned from past experiences, and that they are not quickly embracing risk assets just because they might go up.  The fact that investors are carefully weighing their feelings about risk and reward is a very healthy development.  Part of the whole sub-prime fiasco was due to investors not accurately measuring risk (why is that AAA-rated mortgage bond yielding more than other AAA-rated bonds?), and the consequences which followed taught us all a lot about the risk/reward continuum.

Indeed, this is a rally which is hard to love.  But then, most bull markets begin in the detritus of a recession.  They are hatched under the cold light of dimmed expectations and loss.  They are nurtured by fragile and tottering economies.  They appear truly healthy and strong and receive universal adoration by the masses only when they are near the end of their run.  Yes, bull markets usually end only when the most conservative investor places his last farthing into that “can’t fail” spec trade or the person so close to retirement “finally” shifts all of her 401k money into small cap growth funds.

Early bull markets aren’t meant to be loved.  Because we can’t truly be sure what they are, it is normal to fear them a bit.  Those who can accept the risk inherent in the young bull should be rewarded more than those who wait “for the dust to clear.”  I believe that focusing on the big picture (the big three positives – growing earnings, low interest rates and bearish sentiment) is really the best way to invest right now. The occasional bad day in the market or disappointing economic data point may be enough to cause a lump in the throat, but not enough to force a course change.

Happy Autumnal Equinox!

Today is the day when people in the Northern Hemisphere celebrate (if that is indeed the right word), the end of summer and the beginning of autumn. This equinox brings a feeling of transition as we move from one season to another; a sense of motion as we move from one place to another. It also brings with it a sense of balance, as we experience on this day the same amount of day and night, dark and light. Many cultures have a strong tradition of a harvest festival, and often these celebrations coincide with the Autumnal Equinox. Even Wiccans and other neo-pagans hold the day in high regard.

As I reflect on this day of transition, this day of balance, this day of harvest, I wonder if all those people telling me to take some profits may be on to something. After all, the market has rallied over 50% since early March, and some people tell me this is the biggest rally in this short period of time since the 1970s. Before that, one would have to look back to the 1930s for this kind of strength. The negative case for the market still carries sizable weight – weak economy, weak U.S. dollar, growing government deficits, high unemployment, unending series of bank failures, fear of rising inflation, financial scandals, key industries on government life support, and so on. Why should the stock market be going up with all this bad news out there?

I think measuring the market’s performance from its crisis low may be misleading. First of all, there’s the math involved. If a stock falls 30%, say from $100 to $70, it needs to rise 42.9% to get back to $100 (do the math). So a rally that simply brings the market back to its starting place will appear “bigger” than the preceding decline. Second, the price of a stock is actually the result of a very complex series of decisions, measurements, and calculations made by a large number of (usually) very smart people. Although it looks like a simple number, it represents so much more. When a stock moves from one price to another, it does so driven by net result of all kinds of investors trading the stock for all kinds of reasons. Although we can simply measure the distance between the two points, this number tells us very little about why the stock moved to where it is and probably tells us nothing about where it is going.

In my experience, three key factors impact stock prices – earnings, interest rates and sentiment. Earnings can be affected by the economy, but excellence in execution and/or good fortune can often be more important. That said, an improving economy is usually good for earnings. The level and direction of interest rates affects valuation and influences investor choices. When rates are high, stock valuations tend to be low and visa versa. Generally, falling interest rates are good for valuations, but rising rates (if accompanied by strong economic growth) does not necessarily hurt the stock market. Sentiment, in my view, is usually a contrarian indicator; that is, when everyone is bullish, the market is near a top and when bearishness reigns, a bottom is at hand (reflect for a moment how bullish you were in early March of this year…)

So where do we stand now on these three factors? The economy is improving – consensus expects positive GDP in the third quarter. A majority of companies are raising expectations for the balance of 2009 and 2010. Earnings = Big positive. Interest rates are very, very low, and although some fear higher rates in the future, I would argue that they would have to rise a lot from here to significantly impact stock valuations. Interest Rates = Positive. Despite the rally, sentiment remains mixed to bearish. We have not yet seen the retail investor plow back into the market. Trillions of dollars still remain on the sidelines in “safe” money market funds. Sentiment = Positive.

I don’t make predictions (I used to do it professionally), but it would be very unusual for the stock market to enter another bear phase now with ALL of the important determinants of share prices so clearly in positive territory. Pauses and corrections are the norm for any near bull market and I would not be surprised to see them sometime down the road. Yet, I think anyone trying to wait for a big pull back to get back into the market might be disappointed.

Instead of looking to harvest some profits here, investors may want to consider the possibility of a new transition – from a bear market rebound into a new, real bull market. Maybe we are only half way into this move upward, the balance of which could take us up another 300 points+ on the S&P 500…