The Weekly View: Stocks Break Out on EU Deal and Better US Data
Comment of the Day

November 01 2011

Commentary by David Fuller

The Weekly View: Stocks Break Out on EU Deal and Better US Data

My thanks to Rod Smyth, Bill Ryder and Ken Liu for their astute letter published by RiverFront Investment Group. Here is the opening paragraph:
Investors cheered last week's EU statement because it showed policymakers reached a broad agreement to recapitalize the banking system, leverage their bailout fund, and substantially write down Greek debt. While the outlines are encouraging, the details still need to be filled in to support the rally in risk assets. Since there was a great deal of skepticism around whether a deal was even possible, we think the market responded rationally as the threat of a 'Lehman like' systemic event has been significantly reduced. The magnitude of the fear built into stocks, relative to bonds and cash, is illustrated in our Weekly Chart. The earnings yield for the S&P 500, at 6.8%, is nearly three times that of an interest rate composite of cash, 10-year Treasuries, and corporate bonds - a 40-year high according to Ned Davis Research. The earnings yield is calculated by dividing the price by the earnings per share. It reflects the annual earnings of a company or index expressed as a percentage 'yield'.

David Fuller's view As investors, we currently inhabit a fear-driven world, in which the fear of being long in a falling market is even greater than the fear of being underinvested in a rising market.

There are certainly economic problems in the west to be fearful of, not least Europe's sovereign debt and banking insolvency crisis. However, I maintain that high frequency trading is persistently exacerbating volatility way beyond what investors have experienced in earlier decades, understandably making them even more fearful.

The silver lining in this environment is that it often makes valuations for shares that we are interested in owning more attractive than might otherwise be the case. Moreover, a good number of performing shares reached new highs for the year last month, despite Europhobia and below historic average US GDP growth.

There is nothing wrong with feeling frightened. It can be a good mechanism for risk awareness. However, we should not let fear paralyse us when an objective and unemotional assessment indicates that worthwhile opportunities are available in equities which show positive relative performance.

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