Global stock markets continue to display strong underlying strength as the “end of the world” scenario has seemingly been taken off the table, investors return to more normal trading patterns, and institutions begin to adjust price based on perceived risk. The US markets, both bond and stock, have become more stable and more rational since last fall. Investors are becoming more confident as volatility decreases. As reported by AMG data services, both bond and stock mutual funds are receiving more cash on a weekly basis.
Our risk assessment is that the US market averages (S&P 500) are in the range of fair valuation as mentioned in the Earnings Matter article on May 8th. Our fair valuation assumes earnings for the S&P 500 will increase to roughly $62 by year end; the estimate at the end of the first quarter. Current estimates for S&P 500 earnings for 2009 are $54.00, a slight decrease from one month ago. Earnings are not yet being adjusted upward, but are not being lowered at a rapid pace. If conditions continue to improve, we could expect upward adjustments to earnings estimates after second quarter earnings are released by companies in July. If earnings estimates increase, this will help support higher stock valuations. If earnings estimates don't increase and markets continue higher, stocks will likely become significantly overvalued.
Investors seem to be pricing in a full recovery and significant earnings growth by the end of 2009. While this is definitely possible and recent economic indicators are less bad, any deviation from this implied recovery scenario could result in more volatile markets as risk and valuations are adjusted. In other words, markets are preparing for best case scenario and if it doesn't happen, volatility will likely increase. Since markets are extremely dynamic, outlooks and assumptions change constantly. There is no predetermined direction or course of action. In March, market participants were pricing in a very dire economic environment. As conditions have become less bad, market participants are quickly pricing in a full recovery.
So where do we go from here? Do we have a full recovery or do economic conditions begin to deteriorate again? It is difficult to know for sure, but it is likely something between these two extremes is the probable direction for the economy. The market currently has a great deal of positive momentum and this can continue for an extended period of time. We believe in this type of environment the best course of action is to contemplate various scenarios (positive and negative) and prepare for possible outcomes. It is difficult to intellectually and emotionally make decisions going against the market trend – such as, buying if the Dow drops 2,000 points or selling if it increases 2,000 points. This is why preparation is important. Too many people make decisions either based on emotion at the moment or without proper thought.
So, with financial Armageddon not likely given the massive liquidity intervention by the government (this liquidity push will have other unintended consequences, but we’ll save that for another day) and stocks more or less near fair valuation given an increase in earnings, investors want to remain patient and focus on an opportunistic approach of adding selective stock, bond, country, and commodity exposure as opportunities arise; especially if corporate earnings estimates begin to increase. Of course, the actual level of exposure should be dictated by one's own risk profile and tolerance for volatility. In addition, one wants to be prepared for any adverse conditions which may arise (another crisis for example) or a negative change to the perceived strength of the economic recovery.
