Forget Where Stocks Were, The Question is 'Where Are They Going?'

Monday, December 13, 2010

Were you just a spectator to the rally from the bear market lows?

The S&P 500 has rallied 86% off the March 9th intraday lows. The move has been a spectacular opportunity to make money in the stock market if you were smart enough and/or lucky enough to buy near the bottom. But now we come to today, what should an investor do? Does it matter that we've just rallied so much? Absolutely not! An investor cannot make money from past prices, he can only profit from the future.

Stock market investors need to think about the past like businesses look at past investments. Any investment a firm engaged in up until today must always be seen as a sunk cost. The capital has been poured in, it is gone and entirely irrelevant in future decision-making. The choice of which projects to pursue should be made with the goal of maximizing profitability down the road. This judgment is advanced irregardless of the possibly large amount of time and resources poured into previous projects. The downfall of many investors and firms is their commitment to past decisions and their inability to pivot into more profitable options. The rally over the last 21 months is a sunk opportunity cost and should be wholly ignored when making a investment decision today.

Just ignore the charts for now

My contention is that charting is at its best at tops and bottoms in markets, when the whole world is paying attention to price itself. The front pages and headlines ring out during these times informing everyone that prices are making new highs or new lows. Chartists thrive in these irrational environments because investors focus on past price, which is an inherently irrational act. Greed and the fear of missing out drives investors to buy stocks because they are pushing out to new highs and panic fuels selling because stocks are hitting new lows. These behaviors vault the chartist's strategy into favor for short time periods as the breakout and breakdown prophecies are self-fulfilled. In a circular sense, the chartist is the most rational during this time because his strategy is the only one that works as fundamentals and technical oscillators are thrown out the window. Yet, this cannot last for long.

Eventually the herd recogizes the silliness of making investment decisions based on just the price movement itself and slowly recovers its senses. The crowd once again begins to ignore the regular price fluctuations as they diminish in amplitude and rediscovers its confidence in the long-term growth of the economy and its firms, assuming that belief is substantiated. Simply, the rational investor does not care where prices have been, only where they're going. Once the wild emotions calm, prices will revert back to trading inline with long-term earnings expectations.

What does the future look like?

Jeff Miller over at A Dash of Insight penned an excellent post last week about market valuations in the Spring of 2009 compared with current levels. He argues that stocks are priced more attractively on a forward basis when considering the risks to estimates than they were in the late Spring of 2009. He sees the market garnering a higher multiple in 2011.

The S&P 500 in May 2009, a couple of months after the bear market lows were put in, was priced at 15.37 times forward earnings estimates. Yet, at today's prices, the market is priced 13.35 times forward expectations. This is counter to what we would anticipate given the pervasive uncertainty about the future felt in 2009 versus today. The market's fear was reflected in the VIX reading north of 30 at the bottom against the sub-20 range seen today. A more certain future should earn a higher multiple by investors.

There are plenty of possible world events out there to worry investors. What if the euro disintegrates? What if China's property bubble pops? What if California or Illinois defaults? What if terrorists blow up a nuclear facility? What if crazy Kim attacks South Korea? What if a meteor hits Earth? What if the sun blows up? There's always plenty to worry about in the world (and universe I guess), this will never change. But it's important to understand that we have just saved the financial system from flying off a cliff and we're in the mending process. The trend is up, the financial system has stabilized and companies are making more money. Forget that we're up 86% off the bottom, it's irrelevant. There may be plenty of money to be made going forward with the right outlook and some faith in the global growth story.

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: No relevant position
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