Just when the bears were starting to roar, the market reversed course toward the end of June and rallied sharply through the first week of July. Then, before the bulls could boast too loudly, a weak jobs report stopped the market in its tracks. I suspect that the market may be stuck within this type of volatile trading range for an extended period of time, confounding bulls and bears alike. While these market gyrations may average 5-10% from peak to trough, individual stocks may exhibit much wider trading ranges approximating 20-40%. While this may frighten the faint of heart, it actually creates opportunities that can be exploited. The key to take advantage of this volatility, on an individual stock basis, is to understand relative valuation.
Relative to past and peers… Most stocks trade within a forecastable valuation range, on a long-term basis, relative to history as well as their respective peer grou
ps. The bottom end of a valuation range is usually associated with some identifiable concern or fundamental problem impacting the stock. Conversely, the top end of a valuation range occurs when the company is hitting on all cylinders. The dynamics of a competitive business environment produce these natural ebbs and flows between companies, driving valuation from one extreme to the other.
The mistake too often made by investors is to extrapolate current conditions at either extreme. At the bottom, when pessimism reigns, investors have little faith in a fundamental turnaround. While at the top, when exuberance rules, investors anticipate the good times lasting well into the future. Both of these mistakes can be costly and ignore the natural trading dynamics inherent in a competitive market. Yet market pundits and prognosticators are quick to offer rationale why extreme conditions will continue. They appeal to the two emotions that have challenged investment decision making forever – fear and greed.
Bailing out when you’re fearful and betting the ranch when you’re supremely confident reminds me of a famous quote from Albert Einstein, “Insanity is doing the same thing over and over again and expecting different results.” As long as this trading range market persists, we will focus on avoiding emotional extremes within our disciplined approach to valuation.
An important catalyst on the horizon is meaningful progress in Washington regarding reducing our federal deficit. At the risk of being scolded by Einstein, I think our political leaders will come through in the clutch, notwithstanding another quote by Einstein - "The problems we face today cannot be solved from the same level of thinking that created them."
In any event, as we all know, the clock is ticking.
While the bulls and bears battle it out, it makes one wonder what could give birth to the next sustained market advance. 
As I have written several times in the past, all sustainable bull markets need a theme. This theme produces leadership, which spawns rising investor sentiment, and ultimately a tailwind for the overall market. The explosive growth of the Internet in the 1990s was the most recent example of a powerful theme which led the market to historic highs. Without leadership, market advances are not sustainable.
Given the uncertain economic environment and unclear political picture as we gear up for the 2012 elections, it is hard to see the market entering an extended bull phase. Short term rallies like the one we have just witnessed may be explosive, but I don’t think they will last long.
But this does not mean the fearmongers’ worst case scenario will come true either. Market pullbacks will likely be buying opportunities. So, be patient, be disciplined, and be prepared for trends to reverse frequently and unpredictably. Similar to the weather in Upstate New York, which changes often, each day.
Michael Kayes, CFA
