October 2, 2010 Market Outlook

Continuing from the last couple weeks, both stocks and bonds have advanced. The 10 year yield is down, and the 5 year fixed mortgage rate remains unchanged. It seems that, despite the impressive performance of the stock market over the past month, most investors still feel risk-averse. Inflation dropped 0.1%, but at the same time, inflation expectations are higher. Despite concerns, the probability of a bear market at this point very small. The yield curve is steepening, which makes banks more profitable.

Stocks ended the month 1.8% higher, and the quarter 10.4% higher. Stocks have excellent momentum, moving ahead faster than bonds, although bonds have also been increasing in value. Merger and acquisition activity is picking up, as executives see cash accumulating and the value of rivals appear attractive. Institutional managers are also seeing opportunities to put their cash to work by reinvesting in the stock market. There may have been some quarter-end window dressing, as managers wish to appear fully invested after a very strong run. However, this strength should carry us through to the end of the year.

I’ve been saying that the stock market is not overvalued unless earning growth is lower than about 30% over the next 12 months. That number is large, unless the economy recovers from the recent recession. Earnings season is approaching and we’ll soon see whether or not that expectation is reasonable. However, I listened to the presentation of a professional investment manager, and he’s excited about the opportunity. He sees earnings growth of 50% as a reasonable expectation and, to back it up, he pointed out how much cash companies have on their balance sheets and the recent mergers and acquisitions, which usually indicate that cash is available to corporations for investment and that share prices are seen as cheap. And given the great performance of the stock market over the past month, it’s easier than ever to be optimistic about investing in this current environment.

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