What Hath the Rally Wrought?

This rally in financial assets is relentless. Perhaps the non-professional doesn't appreciate just how extraordinary it has been but friend Barry Ritholtz of The Big Picture blog has ranked it in terms of return over time and it's in the upper 1% of rallies.

Everyone needs to assess their risk tolerance. This has been a risky market since the Lehman Brothers blowup (and really for some time before that) and it's a risky market now. The difference has been that this is a risky market that's rising at an incredible pace whereas in Fall of 2008 it was a risky market that was falling at an incredible pace. Nimble traders LOVE these kinds of markets.

I don't pen my thoughts in this area for traders. I do it for investors. Big difference. Traders can trade ANYTHING. Investors look at what is possible over their relevant timeframe and allocate capital or decide not to.

What is one of my favorite sources of long term valuation (Smithers & Co.) saying about this market? Take a look:


US CAPE and q chart

With the publication of the Flow of Funds data up to the end of 2009 (on 11th March 2010) we have updated our calculations for q and CAPE, which show very little change from our previous calculations.

Non-financial companies, including both quoted and unquoted, were 52% overvalued according to q at the end of 2009. Net worth is virtually unchanged from Q3 to Q4. Domestic net worth fell through dividends ($83 bn.) plus net equity buy-backs ($95 bn.) being greater than net domestic profits after tax ($164 bn.), but this was offset by some small upward revisions to asset values. There was a small increase in the value of US foreign investment abroad ($27bn.), but this was less than the amount of foreign earnings retained abroad, probably due to currency adjustments.

The listed companies in the S&P 500 index, which include financials, were 50% overvalued according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website.

Can you make money in overvalued markets? Absolutely. These conditions can persist for years just as they did in the period 1995-1999 and 2004-2007. Investors who were out of the market in those years due to overvaluation concerns missed some very nice returns. They also missed some horrendous subsequent declines. Those declines have the unfortunate effect of shaking a lot of investors out of their positions in the market. They then miss the subsequent gains. We have spoken of this before.

I am just sharing a valuable source of information. That being said, I am constructively long here with a good deal of risk management in place. It will be interesting to see how this resolves itself.