The Only Certainty Is Uncertainty

10/12/2009


We all know Mark Twain was right when he observed that “the art of prophecy is difficult, especially with respect to the future.”

We all know prophesying is especially difficult in the stock market, where current prices reflect the collective forward-looking judgment of thousands of highly motivated and highly educated investors.

Yet we listen with straight faces as strategists make year-end predictions for the S&P 500 Index.

In part, our suspended disbelief reflects the semantics of Wall Street; a target well above current prices means a strategist is bullish, and vice versa. What’s the harm in that?

Beyond the evils of charlatanism, the biggest danger with predictions is their tendency to lock you into a particular viewpoint. If your strategy depends on betting on predictions, your results will be as good as your ability to foresee the future — something few do well consistently.

Worse, you may begin to view the world through the prism of your predictions. News or market action supporting your viewpoint will be viewed as confirmation of the truth, while developments undermining your prediction will be dismissed as noise or wrong-headed.

To avoid this trap, don’t make all-or-nothing bets and don’t get your ego involved in your forecasts. Emphasize objective, disciplined approaches that tilt the odds in your favor. For our money, stock-market exposure should hinge on two factors:

The primary trend. History shows that when both the Dow Industrials and Dow Transports are reaching significant highs, the primary trend is bullish and higher stock prices are likely. The size of the rally since March has made it less likely that the March lows will be broken, and a breakout above the September highs of 9,829.87 in the Industrials and 4,015.16 in the Transports could prompt us to shift more money into stocks. But until the averages suffer significant corrections — and then rebound to close above the precorrection highs — we intend to hold some of our equity portfolios in short-term bonds.

The availability of attractively valued stocks. Among all U.S.-traded stocks with trailing price/earnings ratios above 0 and below 75, the current average P/E of 19 is in line with the norm since 1990. Among the large and mostly higher-quality stocks in the S&P 500, the average of 17 represents a 15% discount to the norm. Based on other measures of quality, like long-term growth or return on equity, high-quality stocks trade at historically wide discounts to the average stock. With the typical stock trading at reasonable valuations — and higher-quality names trading at a discount — we feel comfortable holding 70% to 75% of our equity portfolios in stocks.


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