Yesterday’s powerful rise in the stock market offers an easy target for rationalizing that the five-month-old correction in equities is over. Perhaps, but your editor is suspicious.
Yes, there’s no getting around the fact that yesterday’s 3.7% jump in the S&P 500 is one of the better daily gains on record. But the human mind is too easily influenced by the most recent events while minimizing older trends. For our money, the older trends are still in force, which is to say that all the obvious threats to a sunny outlook for stock prices still apply: Higher energy prices, continuing fallout from real estate, the accumulating evidence of an economic slowdown or worse, and so on. All of these items, and more, threaten to weigh on the stock market in the weeks and months ahead. One more Fed decision intent on liquefying the otherwise gummed-up credit market doesn’t materially change much for this writer’s intermediate term outlook.
Yes, the Fed’s accumulating actions will eventually be a contributing factor that turns the strategic sentiment to positive. But the idea that this moment arrived yesterday afternoon looks slightly premature.
That’s only a guess, of course, and so the new bull market may be underway as we write. The S&P 500 was off roughly 15% as of yesterday’s intraday low from the all-time high set last October. That’s hardly trivial. But considering the context of the last several months, one can reason that the selling is driven by the fundamental deterioration in general economic conditions. If so, the central question is whether those deteriorating conditions have ended or are about to end in the near future? On both counts, our forecast is “no.”
Again, we have no way of knowing for sure and so one shouldn’t fully discount the possibility that the stock market’s headed for higher ground. In fact, there’s an inherent danger in assuming that economic cycles and stock market cycles align in real time. In fact, they very definitely do not. That’s an important caveat to keep in mind in the months ahead. The risk of being early or late is forever present in timing the bottom, which convinces us to diversify strategic and tactical bets over time as a tool for grabbing the opportunities that corrections inevitably offer while keeping risk at bay.

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Markets correct, valuations become more attractive and expected returns rise. It’s no short cut to quick riches, but paying attention to valuation offers strategic-minded investors the opportunity to improve risk-adjusted returns compared to simply buying and holding.
Savvy investors have long preached no less. Graham and Dodd’s Security Analysis is the bible for analyzing securities in search of market prices trading at less than intrinsic value. The academic literature has increasingly come around to this perspective over the past 20 years as well. Buying low and selling high, in short, boasts support from both practitioners and academics. What works for individual securities looks no less appealing for broader measures of equities and asset classes too.
The devil, of course, is in the details. While it’s easy to argue that buying low and selling high is the only way to fly, there’s the perennial problem of timing. The mere arrival of higher-than-average dividend yields, or lower-than-average p/e ratios is hardly the investment equivalent of blasting the all-clear signal. Stocks can get cheaper for longer than a sunny optimist assumes. That doesn’t mean we should ignore valuation; rather, we must understand the potential risks as well as rewards that come with shopping for value.
With that in mind, we present a brief history of trailing dividend yields for equity markets in the developed world as of last month’s close. As the chart below shows, valuations look relatively more attractive today compared with the past two years. Europe is particularly alluring compared with the U.S., according to S&P/Citigroup Global Equity Indices.
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Meanwhile, our second graph below shows that forecasts of p/e ratios for the fiscal year ahead also compare favorably these days relative to the recent past. Europe is also out on front on this metric: its forward p/e dropped to 11.4 as of February’s close–the lowest since at least the mid-1990s. (Asia Pacific developed p/e ratios were left out of the second chart because of the absurdly high valuations of a few years back due to Japan. As a result, a graphic comparison between Asia Pacific developed and other regions is difficult. In any case, recent trends in Asia Pacific developed forward p/es reflect falling ratios elsewhere in the world. At the end of last month, Asia Pacific developed’s forward p/e was 14.2, down from the mid- to high-teens of the past 24 months and currently just slightly above the U.S. forward p/e of 13.9.)
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What does it all mean? For starters, equities are becoming relatively more attractive. Of course, they may get even more attractive, which is to say the correction may roll on. We don’t know for sure, and neither does any one else. As such, caveat emptor. That said, rest assured that what was overpriced is, for the moment, moving towards being fairly priced and, perhaps, that will lead to inexpensive pricing. The process is underway as we speak, although where it stops, nobody knows.

There’s more than a week to go before the Fed’s next scheduled FOMC meeting on March 18, but judging by the February employment report released this morning the odds of another rate cut look virtually assured.
Payroll employment slumped by 63,000 last month, the Labor Department reported today. That’s the second monthly decline and the steepest in nearly five years. Perhaps the economy’s capacity for minting new jobs is set to rebound, but it doesn’t look that way. As our chart below suggests, cyclical downturns have been known to run for a while, suggesting that at this moment it’s premature to think that the economy has now purged itself of excess.

Yes, the previous downturn was extraordinary in some ways and so perhaps the recent past isn’t necessarily prologue this time around. The hope is that the current slump will be short and mild, but as always there’s no guarantee. In fact, there are more than a few reasons to think that we may be in store for something more than a brief rough patch. For example, mortgage foreclosures jumped to an all-time high at last year’s close, the Mortgage Bankers Association reported yesterday. Meanwhile, home equity dropped under 50% for the first time since World War II in last year’s fourth quarter, according to the Federal Reserve.

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It’s said that investors learn more from their mistakes than their successes. If so, most of us are a lot wiser today compared with a year ago. If so, much of the progress in controlling cognitive bias relates to understanding risk. Such insight doesn’t come easy, nor does it insure success in the future although we’re confident that ignorance of risk eventually leads to failure.
With that in mind, consider a recently published essay by Malcolm Knight, general manager of the Bank for International Settlements. In a speech late last month, given at the Ninth Annual Risk Management Convention and Exhibition of the Global Association of Risk Professionals, he discussed what he sees as the major surprises and non-surprises that have defined much of market activity since roughly mid-2007. Perspective is no short cut to profits, but a healthy dose of historical context may save us from grief later on.
An excerpt from Malcom Knight’s Feb. 26, 2008 lecture on risk:
Some of these problems could have been foreseen, and indeed some observers had expressed strong warnings well before the turmoil. Which developments should not have come as a surprise? And what has been genuinely surprising? Let me highlight three non-surprises and three surprises.
The first non-surprise was the sharp repricing of risk that began in the middle of last year. The signs of an underpricing of risk had not been hard to discern beforehand. A month before the turmoil, we issued our BIS Annual Report for 2007 and repeated our grave concerns about the build-up of financial imbalances and their potential disorderly unwinding. Admittedly, it was impossible to predict the timing of the repricing. But the likelihood that it would occur was not. Indeed, in one respect the fact that it did occur is actually welcome: had the underpricing continued, the eventual adjustment would have been worse.

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Forex is hot, your editor observes in the March issue of Wealth Manager, and for all the obvious reasons, starting with the fact that the formerly mighty dollar has come under the attack of the bears these past few years. No wonder, then, that a rising number of investment strategists in the U.S. see currencies generally as a separate and distinct asset class. It all looks good on paper, but does treating forex as one more choice in asset allocation plans stand up to reason in practice? Exploring the question is the subject du jour, and you can find a full serving here….

The power of diversifying across asset classes has rarely been more convincing than it was last month. Perhaps even more notable is the fact that the winners and losers of late are beginning to reflect the longer term trend.
Consider the table below, which ranks February’s total return among the major asset classes. Commodities were the top peformer, surging more than 12% last month. In fact, raw materials were in the lead for the past 12 months. At the bottom of the rankings: REITs, the big loser for February and for the past year too.

No one knows when the correction will end, but it’s worth reminding that the division between bull and bear markets across asset classes is nearly evenly divided. Recognizing that momentum doesn’t last forever (because it inevitably gives way to the value factor, and then vice versa) has us thinking about the next big shift in strategic portfolio design and how we might take advantage.
For now, momentum has the upper hand, which is to say the winners keep winning and the losers keep losing. For now….