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Taking a Contrarian Approach to Today’s Stock Market

Banks are failing, unemployment isn’t easing up, the housing market is on life support, and the International Monetary Fund (IMF) has even uttered the nasty D-word (depression), so why would anyone in their right mind consider buying stocks now?

Investors have been focused on the negatives, that much is clear.  The simple fact is, stock prices have not.  Over the past 18 months the S&P 500 has climbed roughly 80% from the 2009 panic lows that followed the Bear Sterns collapse and the AIG bailout.

As the rally gained strength, investors began to find courage that perhaps the worst was out of the way, yet most still failed to pull the trigger and buy because the financial media wielded the words “double dip recession” like an executioner wields an axe.

Stuck on the sidelines earning returns that will be swallowed by inflation in their money market accounts had to be painfully frustrating as prices continued to rise even as the din of negativity surrounding the economic outlook grew louder, which leads us to the question:

What to do now?

Current Investor Climate

U.S. Gross Domestic Product, (GDP), rose to an annual rate of 1.7% in the second quarter of 2010, slightly higher than the 1.6% previously reported.  These are recessionary numbers, but certainly not depressionary; growth is growth, is it not?  Likewise, earnings have topped estimates at 77 percent of the 316 companies in the S&P 500 that have reported results since July 12, while government reports on building permits and industrial production showed unanticipated growth, according to data compiled by Bloomberg.

In fact, we currently have a bull market scenario in which earnings are rising, while inflation and interest rates are falling so everything is not quite as grim as some would have us think.

Current Market Valuations

Investors who have thus far missed the boat on this bull market may be surprised to learn that stock prices are almost as cheap today as they were when those smart guys caught the bottom in 2009.  It is counter-intuitive to be sure, but stock prices tell us little or nothing about company valuation, it’s company earnings that give us the real value of the markets.  And right now, with 77 percent of the S&P 500 beating estimates, the market can reasonably be considered cheap even after the 80% rise in the markets since March, 2009.

The Trend is Your Friend

No one knows where the market is going to be in 5 years, much less next year, but it is reasonable to assume that a year from now investors may still be kicking themselves like they are now for not getting on board when they had the chance.

The markets are currently in a confirmed uptrend, and as we noted above, fundamentally the markets are in the midst of a bull market scenario and prices are undervalued.

To be sure, there are negatives out there and there are reasons to be fearful.  Just keep in mind that bull markets thrive on fear and tend to climb walls of worry.  It’s when there is nothing left to fear when everyone is back buying stocks that investors should start to sell and it’s in climates like this that they should be swallowing that bad taste in their mouths and buy stocks despite their concerns.

Don’t Fight the Fed

In their September, 2010 press release the Fed re-affirmed its plan to hold the Fed Funds Rate near zero percent “for an extended period”  Low rates keep margin prices low for investors, make borrowing cheap allowing companies to expand, and makes holding cash and cash deposits less attractive for investors and companies alike.

Bottom line, historically when the Fed is hawkish it’s a good time to invest and a bad time to sell, especially when it happens in the midst of a confirmed uptrend.

This post was featured in the Festival of Stocks

2 Responses to Taking a Contrarian Approach to Today’s Stock Market

  1. I’m in agreement. Many high-quality companies are still very cheap on both an absolute basis and when compared to previous valuations. Especially health care, energy, and some value tech companies.

  2. Richard Stooker says:

    So far, your view that the stock market is relatively cheap and bound to go up has proven correct. Of course, next month might be a different story . . .

    Perhaps current prices are a low which the market will never touch again. Perhaps another financial crisis lies in the future. Nobody knows.

    I believe that stocks may be going up precisely because the overall economy is so poor. So-called safe investments such as Treasuries and money market funds now sport Japanlike yields, and are still undependable in a broad crisis.

    But no matter what happens, people have to eat and use electricity. Therefore, stocks that provide people with goods and services they need and want are in reality the safest investments.

    If the United States devolved into anarchy tomorrow you could forget about Treasuries, but you’ll still want to eat three or more times a day!

    [edit: link removed]

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