Stocks Offer Unfavorable Risk To Reward Ratio

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If you rode the stock market rally from 666 on the S&P to current (1125 as I write this post) consider yourself fortunate. The one-sided strength and persistence for 9 consecutive months has been both surprising and completely consistent with a primary degree bear market rally.

But like all good things… it must come to an end.

I wrote in this post on September 29th (S&P at 1070) that we were likely in the late stages of a bear market rally creating an unfavorable risk to reward ratio. That has proved true as the S&P has traversed both 50 points lower and 50 points higher (1020 – 1125) since that post (1 to 1 risk to reward ratio) and currently sits at the high end of that range after two months of relatively directionless trading. 

Given that the stock market is currently at the high end of this trading range in an unfavorable risk to reward environment I want to reiterate the belief that this is a VERY LATE STAGE bear market rally. I believe many intermediate to long-term investors are being given a last minute holiday gift to reduce risk exposure and re-allocate assets away from risk to safer alternatives.

There remains a minefield of unresolved economic problems, debt problems, and much of the data that looks good is being propped up by government funny-money. In addition, as I wrote in previous posts the housing and mortgage debt crisis has driven much of this decline, and we are now entering the second phase of that mortgage debt crisis. All in all, the economic backdrop is not promising.

I know the media and many of the experts on CNBC are telling you everything is great and the worst is behind us, but I respectfully disagree. 

The underpinnings of the economy and earnings have deteriorated dramatically since the highs in 2007 yet asset valuations don’t fully reflect that deterioration. Something has to give – either the economy will suddenly return to the exuberant days preceding the downturn or asset valuations will adjust downward to reflect underlying economic reality.

Given that asset valuations have already priced in a return to irrational exuberance, I believe it is now prudent to reduce risk in preparation for negative surprises and a downward adjustment.

I will write many more posts this year to continue developing these subjects more fully as the economic crisis continues to unfold, but for now the key point to take away from this update is the importance of conserving capital during unfavorable investment environments (characterized by excessive valuations, excessively optimistic sentiment, and unfavorable fundamentals).

Have a great holiday celebration and I will talk to you again next week as we begin a series of posts on making 2010 your most prosperous year ever.

Happy New Year! 

Related Posts:

Is This Is A New Bull Market Or Bear Market Rally?

How The Mortgage Meltdown Is Driving This Economic Crisis…

Is This Just A Recession Or The Greater Depression?