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Buyer Beware: The Bottom Is Not Yet In


Checking your emotions at the door essential in this market.

Stocks are on a tear again today hitting new recovery highs, as passionately bearish investors just tear their hair out. And that emotional quality is the subject of this article.

In philosophy, "I think, therefore I am" is a truism. In investing, however, it seems that many investors subscribe to the variation, "I feel, therefore I invest." And therein lies the subjective rub that imposes the belief of what "should be" and alters the objective view of "what is."

Taking the current situation, what should be, is captured in the following rather simple (but elegant) fair value valuation table:

15 times $70 S&P 500 operating earnings for the next 12 months (mid 2010) = 1050

1050 minus a reasonably generous discount factor of 10% = 945

As I noted in my blog posting on Tuesday, "…one can debate the inputs and the appropriate discounting time period" however "…Only those with the rosiest of glasses can envision earnings and P/Es greater than those listed above." Well, if valuation levels (based on today's prices and/or assuming a more conservative discount factor) are more than a touch on the rich side, what could explain the new-found enthusiasm of the previously risk-averse investors? One answer can be found in the return of animal spirits via the hedge-fund world.
For example, consider the following 2 comments from Reuters Hedgeworld:

"Hedge fund firm RAB Capital said on Wednesday [July 30] that clients had started putting money back into some of its funds helped by a recent upturn in performance, adding to signs the industry may be recovering."

And, "Hedge fund industry assets increased 7.5% to $1.43 trillion in the second quarter, buoyed by strong returns and lower redemptions by investors."

Then there's the mountain of money sitting in near-zero percent interest rate money-market funds -- a cool $3.5 trillion -- which, even with this morning's rip-roaring rally, represents 40% of the market cap of the S&P 500.

Now, I believe that stocks are more than fully valued. They could even be overvalued, if one concludes that the above-consensus earnings results of the second-quarter company reports contained far too many cost-cutting benefits and far too little top-line revenue growth -- which, by the way, was at consensus expectations compared to the upside surprise to the bottom-line numbers reported.

Moreover, I believe that the US major averages haven't made a completed bottom (see accompanying chart), which requires an upside breakout above their trading range via a mega trend reversal signal.

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No positions in stocks mentioned.
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