Sunday, September 12, 2010

Trading ranges, trend breaks, the new normal and understanding valuation risk.

The long-term bull market that began in the early 1980s and concluded in 2007 provided a very “equities-friendly” environment for many investors. More recently, the market reversal toward the end of April and the “trading range” trap where asset prices swing up and down from week to week has been frustrating. Investors focusing on fundamental company analysis are challenged by the strong influence of macro-economic issues such as sovereign debt, unemployment, housing and slowing economic growth. Against this backdrop, some pundits suggest that stocks should be purchased at current levels because they are cheap.

MY TAKE: Over the long term, financial markets move through economic cycles that can have significantly different investment dynamics. It is important to understand how the risk profile can change when moving from a bullish to a bearish phase. Our current period, often referred to as "the New Normal" - a phrase popularized by Pimco’s CEO and co-chief investment Mohamed El-Erian, suggests an environment with lower investment returns, slower economic growth and higher than normal risk.

Over the past 100 years, three major “trend breaks” have occurred in the US: during the 1930s, the 1970s and the current period. Chart 1 (see page 2) presents the performance of the S&P 500 since 1960 and highlights the two “trend breaks” during this period. Historically, significant economic changes trigger trend breaks. These breaks can alter investor’s views on how asset prices are valued along with their appetite for investment risk. While no two economic cycles are similar, it is helpful to understand how asset valuations have been affected in the past. For example, the average price to earning (P/E) ratio for the S&P 500 from 1960 to the present is 16.6. The high, during 1999, was 29.8 and the low, during 1980, was 6.9. When a trend break occurred during the 1970s, the S&P 500 entered a twelve-year period during which the S&P 500 traded in a P/E range of between 7 and 13. At Friday’s close, the S&P 500 traded at a P/E of 14.6. Given the current level of economic uncertainty, bull market P/E ratios may not be a helpful guide. It is also likely that many of the investment tools and processes developed and used during positive (bullish) phases become less effective during negative (bearish) phases. My approach remains cautious and I continue to apply a process that focuses on managing risk and analyzes free cash flow yield dynamics.

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