It’s not where they’ve been…

It’s easy for anyone, including professional investors, to become paralyzed into inaction by sharp recent price rises, either of the market as a whole or of individual stocks.  Every once in a while, at market tops (in other words, about once every four years), this is the correct stance.  Most of the time, though, it’s not.

Our current situation is a case in point.  The S&P 500 is up 60% from the lows in March.  It’s up 18%, year to date.  Economically sensitive stocks have doubled or tripled off the lows.  Highly financially leveraged firms that seemed on the brink of disaster last winter can be up 5x, or even 10x, from the absolute bottom.  But unless you can somehow go back in time and transact at those prices, the have limited relevance to our investment situation today.

You may regret not having bought, or be patting yourself on the back for having had the courage to act.   Neither emotional state of mind will necessarily help you in your role as an investor, which is to make money from this point on.

(I think it would be instructive, however, to go back and review what pundits were saying about the market at any time from April or May on.  I’m confident that at every point you would find commentators saying the market had gone “too far, too fast,” and was “due for a pullback.”  Their advice?  “Wait for a correction.”  This is what the consensus always says in the early stages of a bull market.  And it’s always wrong.  If you want more information on this topic, look at my posts from March and April.)

The only relevant investment question is “What comes next?”

…it’s where they’re going that counts.

The stock market is a futures market.  The most important questions are always:

what are future profits likely to be–either for the market as a whole, or for sectors or individual stocks you may be looking at?

how much of that is reflected in today’s stock price?

what doesn’t the consensus not yet understand, or what is it not yet looking at?

Where are we now?

I read a research report recently whose summary was, in effect, we’re six months from the bottom and two years from the top.  This conclusion is a variation on the typical four-year inventory/interest rate/election cycle that has been a rough and ready timing tool at least since the Second World War.  The idea is that the stock market goes up for 2 1/2 years, more or less, and then down for 1 1/2.

I don’t whether the precise timing will hold in this cycle, but I do think the spirit of the remark is correct.

We’re way past the panic of March, when investors were convinced (by stunning congressional ineptitude, in my opinion) that Washington lacked the skills to fix the financial crisis.  We now are beginning to get confirmation from other economic indicators of what stocks (a powerful leading indicator themselves) have been telling us for a while–that the recession has just about run its course and that corporate profits are about to rise substantially.

What we haven’t yet begun to do is to make meaningful estimates of what corporate profits are likely to be for 2010 and beyond.  In a way, I think investors as a whole are stuck in the error of looking backward rather than forward.  Perhaps taken aback by the magnitude of the stock market decline, the consensus seems to be unable to imagine the good things that can happen next year and the year after that.  Remember, the S&P would need to rise almost another 50% to reach the last high-water market of 2007.

Who knows whether we’ll reach the 2007 market highs in the US in the current cycle.  On the one hand, it’s hard to imagine the financial stocks, which were such a big part of the market then, playing the same role this time around.  In fact, the previous cycle leaders are most often non-factors for a long while from that point.  On the other, technological and communication innovation is blazing along at a torrid pace.  And, of course, the steep decline we’ve had in the dollar (more to come, I think) make the old highs a less daunting target in local currency terms.

In any event, the economic environment is likely to be supportive for stocks for the next two years or so. I can imagine two main scenarios.  You can probably imagine more (post them as comments, if you like).  Mine are:

1.  plain vanilla The overall market rises 10% per year in 2010 and 2011, which would have the S&P 500 a bit above 1300 by the end of the period.  Overweighting of economically sensitive sectors makes a few percentage points of outperformance possible.  Returns would be much better than those on bonds or cash.

2. late Seventies redux The overall market meanders in a trendless way, making little progress over the next two years.  This general result disguises powerful underlying sectoral movements, both positive and negative, that more or less cancel each other out in the market aggregate.  My guess would be that tech, materials, energy, entertainment all outperform substantially.  Staples utilities, financials are all left behind.  Eventually consumer discretionary joins the positive column.  The net result is that substantial outperformance is possible.  (The key statistic of the second half of the Seventies, in my opinion, is that the smallest 100 by market capitalization of the S&P 500 outperformed the index by at least 25 percentage points each year.)