Until two months ago, I was among the more optimistic voices regarding 2009 outlook for stock prices.  At the end of August I suggested that most markets were approaching long term equilibrium.  This posed a bit of a dilemma for me.   Our success relies primarily upon recognizing disparities between current market prices and the underlying long term value of the assets they represent.   Based on that disparity we radically reduced our stock positions in the summer of 2007 (near the top) and increased our exposure to stocks and high yield bonds in the winter of 2008-2009 (near the bottom).   The result is that our typical client diversified portfolio account has recovered all but about 8% from the market highs in October 07, while our fixed income accounts are up over 20%.  The S&P 500 index is still down about 30%.

During these two months, little has changed.  Stock, bond and real estate prices have moved modestly higher and have now reached what I consider fully valued.  We in turn have continued to reduce our exposure to stocks and high yield bonds.   As a result, we have only captured about 40% of the additional gains of the market during this time.  My strategy has not changed.  In our August 27th comment, I stated, “gains that will take us above 1100 on the S&P are…unlikely, unless preceded by at least the correction posited by our sentiment gauge.”  The correction has not transpired, but despite the continued rally, the S&P 500 has yet to close above 1100 either.  Given that we have tested this level a few times recently, a short-lived bump up to 1120 or 1125 would not be surprising.

At any point in time prices can rise (or fall) further in response to short term factors.   If I am correct in my assessment that 1100 represents long term fair value, the market will return to this level eventually (irrespective of whether the next move is higher or lower).  Therefore I am willing to forego any temporary gains in exchange for the opportunity to acquire new positions at lower prices during a temporary decline.  

Though I posit 1100 as the level, to be more accurate, fair value is better represented by a range than the specific price point.  1100 serves as the midpoint of a fair value range between 950 and 1250.   If the recovery accelerates without inflation, the rally could extend to 1250; conversely, if our best laid plans go awry, we could easily retreat to 950.  Given the experience of the past decade, I consider it highly unlikely that investors will bid aggressively enough to take us to the high end of the fair value range.  Too many individual investors are permanently scarred by the stock market losses of the past decade.  That group will never again commit a large portion of their wealth to the stock market.  Until they are replaced with a new generation of undamaged investors, any rally will be limited to values that can be justified by actual corporate earnings.  Without this class of investors, any breakout from this range would require corporate earnings to post new all time highs ($85+ for S&P).  Even in a best-case scenario, this is unlikely for several years.  

Lacking a crystal ball that perfectly reveals the exact market tops or bottoms, our strategies rely on limiting risk-taking only to times when we are well compensated for it.  From a long term viewpoint, opportunity and risk remain in relatively equal balance.  In the short term there is little opportunity at current prices.  Additionally, given current optimism, there is a genuine risk that investors could panic in the face of a significant decline.  We will maintain our limited stock exposure until the ratio of risk to reward improves.