Enjoying the Rally, but not Relaxed

Investors should relax and stop worrying. That’s my job.

I continue to be more worried about preserving wealth than I am about missing the next market upleg. This weekend’s Barron’s reading was a mixed bag.

The good news was an article, “Trampled in the Rush to Riskier Stocks” by Andrew Bary, that featured stocks in the property & casualty insurance sector, which is a new area of investment in many client portfolios. The article noted that most of the P&C stocks command little or no premium to their accounting (book) value, are currently profitable, and have an opportunity to take business away from the wounded giant, AIG. The hurricane season has been kinder and gentler than in years past. The Price/Earnings ratio of the nine stocks profiled in the article range from 5.9X earnings to 10.1X earnings. If earnings power is maintained and the P/E multiples remain stable, these companies would provide an earnings yield of 9.9% to 16.9%. If earnings power grows, as the analyst in the article expects, or if P/E ratios improve from today’s low levels, investors would benefit even more.

We watched the downward spiral in financial stocks from the sidelines. We are no longer convinced that the sidelines is the best place to be when we look at stocks in the insurance industry, but as always we’ll monitor that view and modify it if necessary.

More of concern was the Lipper fund data which continues to show money coming out of equity mutual funds, in contrast to the surge in July and August that coincided with the big run-up in stock prices.

The Federal Reserve released new data on excess reserves, which is money that is hiding in the banking system but not finding its way out into the real economy, where it could help alleviate some of the financial pressures we are still experiencing. The Wall Street bailout, where public dollars are used to buy up illiquid securities to bail out big banks who were caught in the squeeze, has worked pretty well. Unfortunately, even nine months after excess reserves first surged, the money hasn’t yet made its way out into the real economy. Excess reserves jumped from $823 billion up to about $855 billion, near its all-time high. Regardless of today’s low short-term interest rates, it’s hard to conclude that we’ve got an “easy money” policy if the money sits on the sidelines and is unavailable for job creation and capital investment.

The best news, of course, is that the market has wanted to go up in spite of these fundamental concerns. The Vanguard S&P 500 Index Fund, for example, is +17.8% year-to-date through last Friday, September 25th. Though it was hard to justify higher prices in the fearful days of February and early March, now the S&P 500 sits 57% higher than at its nadir in early March.

Clearly, the volatility inspired by widespread fear in the last months of 2008 and the early days of 2009 created a significant opportunity for profit. Similarly, however, the upside volatility we’ve enjoyed as a function of relief spreading throughout the economy has magnified the risks of decline. Just as we did not put all our money to work at the bottom, I am absolutely certain we won’t be able to define and get out at “the top.” What we will do, however, is carry our bias toward wealth preservation and experience in managing our way through volatile markets into the period ahead..

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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