As meteorologists track Hurricane Earl up the east coast, scientists still haven’t figured out how to accurately predict the path of a hurricane. In the context of this uncertainty, it has always intrigued me to observe the many different methods that people living on the coast employ to prepare for an approaching storm. Some evacuate days in advance. Others ride it out even when instructed to head for higher ground. If the hurricane veers out of the way, those that evacuated face the inconvenience and expense associated with their premature flight to safety. But a direct hit from a powerful hurricane can be a harrowing experience to anyone who threw caution to the wind. Perhaps one day, scientists will figure out how to accurately predict exactly where hurricanes will go. Until then, we are stuck with deciding how cautious we want to be.
The market’s barometric pressure… Investors have to make a similar decision when it comes to investing in what remains a very uncertain environment. And as most investors know, 
there are costs associated with being too cautious as there are with being too aggressive at the wrong time. Thankfully, we can employ statistical tools to gauge the appropriate level of caution, and to determine how much of the risk, or potential negative outcome, has already been discounted by the market. For example, a stock market selling at a price to earnings ratio (P/E) of 29x, as it was toward the peak of the tech bubble in the late 90s, was looking at the future through rose-colored glasses. Unfortunately, we only know this in hindsight. Today, the P/E of the market is less than half that level, selling at about 12x forward earnings. It seems fair to say that the market might be discounting a far more negative future than it did a decade ago. Again, this will only be clear in hindsight.
The combination of better than expected economic news and an oversold market following a very weak August, has led to an impressive rally thus far in September. For starters, the latest jobs data showed greater strength in the private sector than economists were anticipating. At the same time, surprisingly resilient retail sales in the all important back-to-school shopping season is another positive sign for continued economic recovery. In addition, there are increasing indications that corporations are becoming more proactive with their record setting cash flow through share buybacks, higher dividends, and more aggressive mergers & acquisition activity.
Could all this be the start of an extended rally in stock prices? With valuations historically low, perhaps there is reason for optimism. Continued improvement in employment would certainly reinforce the rally, but it is far from clear what the next few jobs reports will show. Uncertainty over taxes, potential deficit reduction initiatives, and the November election continue to cloud corporate decision making as well as the overall market. But despite 
that uncertainty, I think it is fair to say that the market has priced in a great deal of negativity, making it prone to explosive rallies in response to positive news.
Over the past several months money has poured into bond mutual funds, despite historic low interest rates, as investors continue to be risk averse. It is a mirror image of what we saw at the top of the tech bubble, money pouring into equity mutual funds just before the bubble burst. Clearly, investors were too aggressive at the end of the tech bubble. Perhaps they are too pessimistic now.
Staying put… In the meantime, we are riding out the storm of political and economic uncertainty. But while we are hunkered down we are continually looking for ways to reinforce the portfolio by taking advantage of upgrading the quality of our holdings as opportunities present themselves in this volatile environment.
Hope to see you all at one of our receptions next month.
Michael Kayes, CFA
