Currently, there is no investment merit to market risk from the standpoint of valuations, so the only reason to take market risk would be based on speculative merit. While the market has had a speculative run from its early October low, this rally has been driven largely by a retreat of sellers, rather than a measurable and robust shift in the willingness of investors to take risk (as measured by trend uniformity). It's certainly possible that this will change. The easiest way for trend uniformity to become positive on a further market advance, would be a substantial broadening in leadership beyond technology and semiconductors. Even easier would be for trend uniformity to become positive through a substantial decline in the major averages which displays good internal strength. My opinion (which we don't trade on and neither should you) is that this second outcome is more likely. In either event, however, there is little question that we will accept some exposure to market risk in the coming months. What we will not do, however, is substitute fear of regret for objective evidence.
Fear of regret - there are a few factors that drive investors to utter failure, and this is one of them. Fear of regret is why investors piled into dot-com stocks in the late 1990's, in the belief that leaping price advances were sufficient evidence that a new era of unprecedented earnings growth had arrived. Fear of regret is why those same investors refused to sell despite losses that wiped out their financial security. Fear of regret is the primary reason they have been chasing those same battered technology stocks since early October, frantic that they will miss the recovery that could make them whole again. So eager are they to label this rally a new bull market that only 17% of investors surveyed by AAII are bearish - an unusually low level. Bearishness among investment advisors is similarly low. Yet this dearth of bearishness is not universal. As Mark Hulbert of the Hulbert Financial Digest notes, "The stock market timers with the best long-term records are - on balance - quite cautious right now, if not outright bearish. In fact, these top-performing timers are today just as wary of the market as they were last February... And we all know how the stock market has behaved since then."
If there is one thing that is painfully clear, it is that economies running record current account deficits (as the U.S. does today) don't enjoy sustained investment booms. No sustainable investment boom, no sustainable recovery in tech profits. No sustainable recovery in tech profits, no sustainable leadership from tech stocks. This point is consistent with what we are seeing in market action. Specifically, in order for market risk (beta) to have reliable merit, we have to see leadership from something other than tech. In my opinion, the recidivism that drives investors back to information technology stocks on every market rebound is one of the major signs that we are not through this mess. The industries that lead one bull market are never the industries that lead the next.
Our discipline does not require us to make short-term market projections. But as I have noted many times, the long-term behavior of the market is determined heavily by valuations. Unfavorable valuations don't have much impact on short-term returns, but they very reliably indicate that long-term returns are likely to be unsatisfactory. Depending on how one defines bull and bear markets, we will probably experience several bull and bear cycles over the coming decade, with valuation levels reaching more normal (and lower) levels on each successive decline. This is the meaning of a "secular" bear market, and would be similar to what the market experienced between 1965 (when the Dow approached 1000) and 1982 (when it finally bottomed below 800). I certainly expect that we'll have the opportunity to take market risk during many of the intervening advances, but at current valuation levels, there is very little risk of missing much in the way of long-term returns even if we miss certain short-term advances (in hindsight) for lack of sufficient evidence.
As a side note, if pressed, my opinion is that the leadership of the next secular bull market will be companies that operate at the molecular and atomic levels - genetics and nanotechnology, for example. Such technologies are likely to represent true opportunities, because unlike the dot-com bubble (where competitors were unlimited), the availability of patents is likely to create sustainable competitive advantages and profit opportunities. The internet boom represented outstanding technology, but because there were few restrictions preventing competitors, nearly all of the benefits of that technology accrued to consumers, rather than producers. This remains true today. Outstanding technologies are also profitless unless there are barriers to entry. This is one of the things that many current tech investors fail to understand. Still, there will indeed be another "tech" boom, and in my opinion, a much more sustainable one, in the future. Unfortunately, biotech valuations remain too high, and nanotechnology is still years from flourishing even as an emerging growth industry.
In the intervening years, the U.S. current account deficit will come more closely into balance. There are only two ways to do this. Either the U.S. substantially increases its exports, or the U.S. substantially reduces its imports How? Through a reduction in consumption as a share of GDP, a further decline in U.S. domestic investment (probably housing as well as business investment), a substantial devaluation of the U.S. dollar, and a gradual strengthening of foreign economies. But all of this takes time. And if there's one thing that the tech bulls are short on, it's time. If the profit outlook does not improve from the perspective of the coming quarter or two, the current rally would seem quite vulnerable. As always, that's not a forecast, but the foregoing comments are consistent with the information that we infer from market action (trend uniformity). Until this changes, we will unrepentantly avoid market risk.
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