Economics, Valuation, and Fear and Greed

As we close out the third quarter, global stock indexes are at or close to all time highs. It is astonishing when one recalls the catastrophic decline in stock prices and general investor despair that existed just five years ago, compared with today’s more jubilant environment. Now that the bull market is about to turn five years old, many investors are asking how much time and potential is left? Additionally, there is a growing concern that an eventual rise in interest rates will be the death of global stock prices, and bonds as well.

The current bull market, like all markets including real estate, has been fueled by several factors: economics, valuation, and fear and greed. When the market began its ascent in the second quarter of 2009, the economy was bad but was just beginning to recover — good for stock prices. In terms of valuation, stocks were “dirt” cheap in 2009, particularly when related to a possible economic recovery. Lastly, fear amongst investors was possibly at its highest level ever recorded. Bernard Baruch, the infamous investor, once said “buy stocks when there is blood (fear) in the streets” and in 2009 he could not have been proven more correct! As we consider the condition of today’s stock market and level of prices, we should also consider these same factors. In terms of economics, global economic growth is subpar but appears to be stable. This is an excellent environment for stock prices and our research suggests that the risk of recession — the big risk for stock prices — is quite low over the next 18 months. In terms of valuation, though no longer “dirt” cheap, global stock prices are still reasonably priced and not at levels that one would associate with stock market tops. This is particularly true in Europe, where the economy is just beginning to recover. Thankfully, as global investors, we are able to participate in those markets. Lastly, though the level of fear that existed in 2009 is long gone, our research and investor intelligence polls suggest that investor complacency is still unsettled. Many investors, both institutional and individual have been underinvested during most of this bull market and cash and bond fund levels still remain at higher than normal levels. This suggests that we have not quite yet reached the greed phase of this bull market and global stock prices may have quite a bit more room to run to the upside — with normal corrections along the way.

Over the past six months, there has been growing investor concern in regard to the possibility that interest rates will rise significantly. The interest rate market is similar to the stock market in that it is affected by economics, valuation and fear and greed. In terms of valuation, bonds are overpriced and investors have greedily piled into bonds for years. So, on a valuation and fear/greed scale, interest rates will eventually head higher. However, on an economic scale, rates are likely to go nowhere until the global economy starts to demonstrate increased upside momentum — a fact validated by the Federal Reserve last week. When rates do rise, bond prices will decline. Stock prices historically have survived the initial phases of rising interest rates but eventually lose momentum. We are not a point where rates will rise significantly, but our team is watching this very closely.

These are the years that prove the value of investing in financial markets and should be enjoyed while they last. As you know, they do not last forever. Hence we are always considering ways to mitigate the risk of a catastrophic decline in your portfolio through your portfolio’s asset allocation, sector management and the use of carefully placed stop loss orders.

We hope this update finds you well. If you have any questions, or have experienced a significant change in your financial situation please let us know.

All of us appreciate your continued “vote of confidence” in our work.

Sincerely,

Your Team at Main Street Research