The graph below suggests that stock values are not outrageously high, but have now pushed up above the real GDP line, indicating that the bargains are over. Thus, after an approximate 50% rally in stocks since early March, it may be time to consider a more cautious approach to equities. Here are my reasons for recommending caution.

1. As the graph shows equity values are pushing up past their intrinsic value as discussed in our past symposia. It doesn’t mean they can’t go higher, but they can not continue the recent rate of gains in the long run. In the future we should see stocks rise no faster the nominal GDP. That still may be better than bond yields right now, but that too won’t last forever.

2. A 50% rally is something that should prompt late-comers to be wary of the near-term future. Stocks don’t rise forever. Until now, the best 7 month performance in stocks over the past 40 years was a 37% gain during the same March to September time period in 1974 and a 38% gain between December and June 1982. The last half of 1974 saw a 20% downward correction, but the 1982 rally didn’t see a correction until 1983.

3. There was a lot of money on the side lines this spring as thousands of scared investors bailed out, but then painfully watched the recovery unfold this spring while they were out of the market. This summer the rally has been extended as these people who lost billions became afraid that they were quickly losing the chance to recoup their losses. These people are what many in the industry refer to as the “weak hands”. They typically get punished multiple times. It may take a good market correction to scare these investors out of the market again.

4. Wall Street seems to be way too optimistic about the timing and strength of a national economic recovery. They are treating the current recession and “imminent recovery” as though it will follow typical patterns with the stock market leading the way. But this has neither been a typical recession nor will the recovery prove to be a typical recovery. There are still plenty of challenges left before we can be confident that any recovery can stand on its own without continuous stimuli from the Federal government. This question has been asked of me many times, “When do you buy and when do you sell stocks?” My answer is that you never can accurately guess short-term market outcomes because at both troughs and peaks the market is driven by psychological expectations. Fundamentals are of secondary concern. The buy point is when fear has driven expectations far below the likely outcome, and the sell point is when optimism greatly exceeds the likely reality. It seems that we’ve reached that latter point now, and prudence and some pruning may be in order.

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Dr. Barton Smith
Director, Institute for Regional Forecasting