Friday, July 30, 2010


Upside reward and downside market risk now appear to be in balance.

I see nothing in terms of market price action or economic commentary that would dissuade me from my baseline expectation that the S&P 500 will be range-bound between 1,025 and 1,150 over the balance of the year.

Accounting for the weakness in S&P futures this morning, the S&P cash index now trades at about 1,095, so it's right around the middle of my expected second-half low and high for the index.

Hence, upside reward and downside market risk now appear to be in balance.

Some of the rationale for my range-bound expectation:

The forward P/E for the S&P 500 (on a realistic corporate profits estimate) is now under 12x vs. an average over the past three decades of 15.5x and about 17x when inflation and interest rates are quiescent (as they are now).

Yes, the upside to stocks may be capped -- I am using only 13x to get to my 1,150-1,160 S&P target -- by the ambiguity of the current soft economic patch and by the emergence of several nontraditional headwinds (higher marginal tax rates, costly regulation, and federal, state and local imbalances). But the wide gap between historic multiples and today's valuation seems to argue that the concerns are known and discounted.

The downside to stocks will be supported -- I am using 11x, which takes the S&P to the 1,025 level -- by the low probability of a double-dip and by growing evidence of a modest and shallow domestic economic expansion that is capable of sustaining itself.

Normally, I would argue that in a range-bound market, differentiated investment performance (over the next five months) should come from superior individual stock selection and by identifying changing group rotation, but today we live in a risk-on, risk-off world that is heavily affected by the last algorithm standing on a day-to-day basis. With the correlations of different asset classes historically high, the fundamental convictions of a micro ("bottom up") investor will often be challenged (in the months ahead) by the macro world we face.

No comments: