Knowledge is Power

Signs

Anyone who has spent time in a major city has seen this person – the forlorn individual with the homemade placard proclaiming “The End is Near.” Fortunately, the people predicting the end of the world are correct about as often as weather forecasters or stock market prognosticators. Signs, however, dominate our everyday life - as the song says “Signs, signs, everywhere a signs…” - telling us to stop, go, slow down, speed up, and a host of other commands. Investors in the stock market are also confronted by signs every day. These signs might include the latest action of the Federal Reserve, the most recent data on inflation, or an individual on a television program yelling “Buy!” or “Sell” about the current hot stocks.

Investors must learn to read the market signs in order to make prudent decisions in portfolios. However, just as with the signs in everyday life, signs in the market place can be confusing and lead investors to different conclusions. This article will look at two recent stock market signs and demonstrate how varying interpretations of the signs could lead investors to completely different actions in a portfolio.

Inflated Expectations

In case you have not heard – gas prices are up! The price of gas has risen so substantially (approximately 60% since April of 2004) that as I recently drove past a gas station offering regular unleaded fuel for $2.69 per gallon my first thought was, “$2.69 per gallon – what a bargain!” What a difference just a couple of years can make in our perception of fuel prices.

The dramatic increase in gas and other commodity prices also signals a potential warning sign for investors – “Caution – Inflation Ahead.” As discussed in last month’s article, the price of commodities often rise as inflation increases. Thus, the recent spike in commodity prices may be a sign that higher inflation is soon to appear, and a continued increase in inflation has the ability to derail even the healthiest of economies. For example, higher inflation numbers may cause the Federal Reserve to continue to raise key economic interest rates to offset the loss of purchasing power due to rising prices. This action by the Fed will result in higher borrowing costs for both businesses and consumers as banks and other lenders raise interest rates. The higher borrowing costs may discourage purchases by both corporations and individuals, resulting in reduced corporate earnings, slower economic growth, and lower stock market returns.

Others, however, read the higher commodity price signs differently. This interpretation concludes that rising energy and other commodity prices are a result of growing global economic demand. And, while potentially a temporary cause of inflation and other negative forces, growing global demand will drive a healthier international economy, which can only benefit both foreign and domestic stocks.

So the inflation signs can be interpreted as either “Caution” or “Maintain Speed” – which sign are investors to believe?

Running with the Bulls

Since October of 2002 the U.S. stock market (as measured by the S&P 500 Index) has increased by approximately 60%. The current bull market is nearing 44 months in length. Historically, the typical bull market peaks about 22 to 24 months into a stock market recovery and begins to transition into the next bear market after approximately 24 to 36 months. Thus, this current bull market is rather long in the tooth. In addition, S&P 500 companies are currently valued at 18 times last years earnings – a fairly rich valuation compared to the historical average of less than 16 times trailing earnings. Are these signs pointing to a “The End is Near” scenario for the current bull market?

Of course, other signs seem to be pointing to continued prosperity for stocks. The current price/earnings ratios for stocks appear to be high, but the Federal Reserve’s own stock valuation model, which compares stock values to bond values, indicates that stocks are under valued. In addition, most companies continue to report favorable earnings, consumers continue to spend despite higher product prices, and stocks have been able to recover in the face of setbacks.

So, should investors be reading the market signs as “Rough Road Ahead” or “Fasten Your Seatbelts?”

Reduce Speed Ahead

These examples highlight just a few of the contradictory signs given by the economy and stock market every day. How an investor “reads the signs” will dictate whether a portfolio will become more aggressive or conservative through higher or reduced exposure to the stock markets. None of the current stock market signs definitively indicate whether the market will rise or fall in the future, which creates a confusing investing picture. However, when market signs are mixed, a healthy dose of caution should cause prudent investors to slow down their portfolios and consider taking profits from stocks, which could lead to a much smoother investment journey in the future.

Source: Baseline