In a free economy, there are two conditions for achieving profit over the long-term. The first is that one must provide something that is scarce, and the second is that one must provide something that is useful to others. For example, you might open a trendy coffee house, with a great atmosphere and menu. But if you walk out into the street, and see dozens of trendy coffee houses up and down the street that also have a great atmosphere and menu, you should not expect to earn a profit. Even though what you are providing may be desirable and seemingly timely, it is not scarce.
Likewise, you might be the world's only manufacturer of porcupine-needle seat covers. You could even own the patent. But even with the ability to maintain all the scarcity on earth, you should not expect to earn a profit, because that scarcity has not been combined with usefulness to others.
Of course, there are often certain constraints that we might wish to put on otherwise profitable activities, since profits can be obtained by providing things that are scarce and useful to the consumer, but have socially undesirable consequences or are simply illegal from a broader perspective. Likewise, some profits are clearly obtained through fraud or other deception. Still, over the long-term, if an activity (or pattern of activities) does not provide something scarce and useful to others, it will not be profitable over time either.
Investors forget this too often. There is emphatically no basis on which to expect a durable profit in the financial markets unless an investor makes a habit of executing trades that provide some scarce and useful service to others in the market, or to the economy as a whole. Investors who are driven by fundamentals and valuation tend to provide these services when prices are depressed - in the form of liquidity, risk-bearing, scarce capital, and sometimes information from skillful valuation. At these points, the long-term rate of return priced into stocks (which is also the long-term cost of capital for companies issuing new stock in the market) can be very high.
Conversely, when investors are speculating to excess, fundamental investors can sell into this demand, responding to the scarcity of stock and the eagerness of speculators by liquidating shares at elevated prices, and withholding capital from being misallocated into projects having low long-term returns and weak prospects for durable economic benefit. Even if the eager demand of speculators later turns out to be ill-advised, what matters is that the trades provide something desirable to others at the point those trades are made. When value-conscious investors do that repeatedly over the long-term, they provide a stream of scarce and useful services to other market participants and the economy as a whole, and that becomes the basis for expected long-term profit.
The same holds true even for purely technical investment approaches. Those that are successful over time implicitly exercise the habit of accumulating an inventory of securities as early evidence of increased demand emerges, and of liquidating inventory as demand becomes more prevalent and prices become overbought - with particular attention to any evidence that demand has started to wane. This is far more difficult than it sounds, because evidence from price movement typically needs to be confirmed by a variety of other considerations (technical support, breadth, leadership, uniformity across industry groups, trading volume, etc). Even so, the basic rule is simple: you should not expect a profit from trades that contain no expected "edge." In my view, a trade or strategy has an edge when it either immediately provides scarce and useful capital to the economy at a high prospective rate of return (which is what fundamental approaches attempt), or puts you in a position to provide a scarce and useful service to other investors some later time, by accumulating or releasing inventory at a favorable price (which is what good technical approaches attempt).
Surveying the present market environment, it's difficult to see any particular edge that either fundamental or technical investors can expect as a result of buying stocks here. On a fundamental basis, even factoring the most recent data from earnings season, we estimate that the S&P 500 is priced to achieve 10-year total returns in the area of 3.6% annually, contrasting sharply with the nearly 11% prospective returns that were priced into stocks in early 2009. While the prospective returns reflected in March 2009 were far short of those that we've observed at durable lows like 1950, 1974 and 1982 (and in the context of Depression-era credit strains, weren't enough to induce us to accept market risk that would obviously have been rewarding in hindsight), it's clear that the bulk of those prospective gains have now already been achieved.
Put another way, there is little compensation left to be squeezed from the scarce and useful services value-conscious investors might have provided by buying stocks in the panic of late-2008 and 2009. At present valuations, the willingness to accept market risk is neither scarce, nor particularly useful. Advisory bullishness peaked a few weeks ago, along with institutional bullishness, while mutual fund cash levels are easily at the lowest levels in history. We obtain 10-year projected returns in the range of 3-4.5% annually from nearly all of the historically reliable valuation methods we track (i.e. those with numerous decades of strong correlation with subsequent long-term returns, not simply ones that seem reasonable in a sound bite). What possible "edge" would a value-conscious investor obtain from buying stocks at presently elevated valuations, with the S&P 500 near its upper Bollinger band at nearly every resolution?
Likewise, from a technical perspective, it might have been desirable to accumulate an inventory of stock near the beginning of QE2, in hopes of distributing it at higher prices. But those prices have now been realized, and QE2 is closer to its end than investors may recognize. Last year, in early November when QE2 commenced, the monetary base was at $1.985 trillion, and the Fed's SOMA portfolio was at about $2 trillion. As of May 15, the monetary base had expanded to $2.586 trillion (already up by just over $600 billion) and the SOMA portfolio, which has an explicit QE2 target of $2.6 trillion, stood at $2.532 trillion. At the prevailing rate of purchases - approximately $19 billion per week net of MBS reinvestments - the Fed should complete its purchases under QE2 on or about Friday, June 10. Unless one anticipates a burst of demand for stock by speculators during the final days of the Fed's program, one would think that we may have passed the point of ideal inventory liquidation. Little wonder we're observing a clear slowing of price momentum, deteriorating internals in speculative indices such as the Nasdaq and Russell 2000, and price-volume behavior characteristic of persistent distribution.
That's not to rule out the possibility that we could observe yet another burst of speculative demand from some source. Given the recent increase in new claims for unemployment and rollover in a variety of short- and long-leading economic measures, that possibility might even include weak suggestions of further quantitative easing. While I doubt that further Fed purchases would do much for the economy other than set up an even more troublesome adjustment down the road, and while the current batch of Fed governors is more hawkish than what Bernanke had available last fall, we've learned painfully enough not to rule out the possibility of reckless policy decisions. Still, it seems dangerous to base one's "edge" here on the expectation that the Fed will embark on further easing, hoping that fresh demand will follow - even at present valuations - and that further demand will follow upon that which will allow the inventory to be sold at a profit. For our part, we prefer an evidence-based approach that doesn't require our hopes about future scenarios to run overtime.
This is a good time to recall that markets rarely form "V-shaped" peaks or troughs. While the initial blast lower from an overvalued, overbought peak can be very steep, aging bull markets also have a tendency to exhaust a sequence of attempts at "buying the dip" - resulting in a broader, range-bound distribution process that can last for several months. Even here, we're open to the possibility of modest, periodic exposure to market risk depending on the specific set of conditions we observe, but at this point, any exposure we accept is likely to be coupled with a continued "line" of defense using index put options to cover the risk of any abrupt market losses. That said, the overall tone of market internals is deteriorating rather than improving, and with valuations elevated, it's best to view any range-bound rallies with a memory of how things worked out following the apparently "resilient" markets of 2000 and 2007.
While my sense is that many investors and institutions are holding a greater market exposure than is appropriate given present return/risk prospects, I should mention that there isn't a great deal of evidence that bears and short-sellers have a particular "edge" here either. Our own investment stance is defensive but also fairly neutral, and with a preference toward moderate, if transitory, positive exposure. At the point we see a greater deterioration of market internals, particularly if it is coupled with economic deterioration and widening credit spreads, the market environment will probably turn hostile in a more sustained way. For now, I want to be clear that we don't see how accepting market exposure here provides much in the way of scarce or useful services to other investors or the economy - but we also that we don't yet see the internal deterioration that would allow a trader to anticipate aggressive selling with a high probability.
