Investing for 2007: Using Long-term Sentiment to Gain Perspective

Readers who have been following the market valuation series on "A Dash" understand the basic conclusion:  U.S. equities are undervalued when compared to bond returns.

Bill Miller of Legg Mason recently made this point (and thanks to Abnormal Returns , one of our featured sites, for making sure we did not miss it).  He points out that private equity is "buying the cheap asset, which is stock, and selling the expensive asset, which is debt."  This is the smart money, and that is how they are playing it.  Individual investors should take note.

Please also note that the ongoing bearish predictions about the economy, employment, housing bubble impact, inflation, interest rates, hyped earnings, and whatever, have been wrong for three years and counting.  We are in the midst of a multi-year expansion of corporate earnings at compounded double-digit rates.  Estimates have been revised up, not down.  The 1970’s comparisons look worse with each passing quarter.

Anyone who looks at our series with an open mind can see several important conclusions:

• Despite the records in the Dow, the overall market remains undervalued.  It is not too late for the individual investor to participate for major gains.
• Some stocks are fairly valued or overvalued.  That means that many stocks are grossly undervalued.
• Stocks that are linked to economic growth are the ones that have lagged.  The cycle of negativity, the recession hype (overstated probability and impact), and the punishment of any company that does not give a rosy forecast combine to provide a real investment opportunity.  If the market is undervalued by 40%, many of these stocks (which we obviously like) currently trade at a bigger discount.  What if this is the fourth inning of expansion instead of the ninth inning?
• The analysis helps us understand why the market has not had a big correction despite recent gains.  Just as selling continued ad nauseum during the 2001 decline, there is underlying support for undervalued stocks in this market.  Many participants– individual investors, mutual fund managers, and hedge fund managers — are under-invested.  A continuing rally will exacerbate this feeling.
• Valuation helps us to see the risk/reward in the market.  The current levels have discounted a major decline in forward earnings and/or a major increase in interest rates.  It takes very extreme assumptions on either or both to view the current market as fairly valued.  This provides a lot of support for a rally.
• Individual investors at the retail level are not current players.  When sentiment changes (what will be the catalyst?) it can provide the basis for a major move.  Rookie hedge fund managers who are playing the tired theses of the "spent up" consumer and the housing market collapse will be scrambling to cover short positions.

If the long-term sentiment indicator is correct, this is not a question of "if" but a question of "when."

We will continue the series with criticisms and problems related to the "Fed Model," a discussion of possible catalysts, and some exploration of stocks most likely to gain as investors gain confidence in the Fed and the economy.