Stock Investors Having a Ball...

"It's like Cinderella at the ball.  At the start of the party, the punch is flowing and everything's going well, but you know at midnight, it's all going to turn in to pumpkins and mice..."  Warren Buffett

"Midnight" draws closer but just how close is it and why should we care?  I try my best to avoid commentary on "news of the day" or short-term trends but I feel compelled to at least comment on some of my recent market behavior observations since they fall into a big picture view and this information also segues neatly into my forthcoming "Invest Like a Philosopher" entry, "Asset Allocation: The Socratic Model."

As my blog readers know, I believe that a knowledgeable investor can allocate a portfolio by watching macro-economic trends and aligning mutual funds in a way that leverages the knowledge of such trends.  As Mark Twain said, "History does not repeat itself, but it does rhyme."

I've given the example before that large-cap stocks tend to lead market performance in the final stages of an economic cycle and that the stock market is a form of benchmark measuring the future value of the underlying companies, discounted to present value.  In other words, stock performance tends to be a leading economic indicator partly because investors will become less speculative and buy shares of larger, well-known companies in the last stages of an economic cycle as they move from speculative areas, such as small-cap stocks and emerging markets.

Here are a few recent observations that I have noted, which speak to such cycles:

• Large-cap stocks, as measured by the S&P 500 are now officially out-performing small-cap stocks, as measured by the Russell 2000.
• After the 9% drop in the Asian market on February 27, the U.S. market response was a decline of more than 4% for domestic stocks (an over-reaction but, at least, a healthy one).  After Wednesday's drop of 6.5% in China's stock market, the American response this time was a sharp increase for stocks ending in new all time highs on the Dow Jones Industrial Average, the S&P 500, the S&P Midcap 400, the Russell 2000, the DJ Wilshire and a six-year high for the NASDAQ.
• Yesterday was the first day since late 1999 that the Dow and S&P 500 hit records on the same day.
• The current Bull market is four and a half years old.  The average Bull market is around three and half years in duration.
• Investors are ignoring bad news (record gas prices, an eroding housing market) and bidding stock prices into record territory as further evidenced in the surprising positive consumer sentiment report earlier in the week.
• A large contributing factor to the rosy consumer sentiment reading this week is the rise in stock prices, but what are the reasons for rising stock prices?  Overseas strength?  Low unemployment?  Maybe...
• The lack of significant fundamental, rational reasons for stock market strength indicates the market is momentum driven, not fundamentally driven; therefore, much of the support for consumer spending (70% of the economy) may be an illusion of self-feeding, baseless optimism. 

From my view, the only thing keeping this market from being completely irrational is the fact that large-cap stocks, for the most part, still appear fairly valued.  With that said, however, it is in my humble opinion that those "fair valuations" are nearing the point of "priced to perfection."  How much further can stocks run?  Let's take a look at a few things and determine if we really need to care...   

For an interesting reference to this post and as a segue to my next post on asset allocation, I'll use the 2006 Callan Chart. The last two recessions, beginning in 1991 and 2001, respectively, both share some striking resemblances: 

• As recession draws near and just as it begins, the financial markets leader is bonds (the Lehman Brothers Aggregate);
• Then, as the economy "bottoms" and begins to emerge from recession, small-cap stocks gain leadership (Russell 2000 Growth & Value);
• Foreign stock (MSCI EAFE) emerges as the US economy matures;
• Then, marking the beginning of the end of each cycle, leadership by S&P 500 (large-cap stock) resumes.

The next Callan Chart will likely show leadership of the S&P 500 for 2007 -- a perfect completion of the same two previous cycles and a repeat of the classic market leadership pattern.  The only unknown is how long the S&P 500 will run.  One month?  Six Months?  One More Year?  My guess is that there is still room to run but, being a long-term investor, that does not matter to me. 

What's good about being a long-term investor (if you are wise), is the fact that "timing the market" never needs to be (and never should be) a part of our strategy.  As I've stated before, the proper asset allocation should allow the investor to say, "Who cares?" in any market environment.  There are always opportunities to be had no matter what direction the market is moving.  We should stay in the market but simply make small incremental moves as trends begin to reveal themselves.  We only need to have the confidence, courage, and capacity to be wrong for a while in exchange for being "right" most of the time.   

Is it time to get out of the market?  No, not completely.  Should a wise, long-term investor enjoy the current run for stocks while slowly preparing for the next economic cycle?  Yes, most definitely.  Stay tuned for more details...

TFPAuthor, Kent Thune, is the President and Owner of Atlantic Capital Investments, LLC (ACI), a fee-only, registered investment adviser based in Mount Pleasant, SC, near Charleston.  ACI specializes in retirement, investments, and comprehensive financial planning.