There are a lot of good trades out there in this kind of market—some of them are value trades, while others are momentum opportunities. With sentiment in the broader market quite positive, the likelihood of further capital gains in the main stock market averages is strong.
After many years of following the stock market on a daily basis, I’ve gained a healthy respect for the other side of the market. I’m not referring to being short; what I’m talking about is risk. I spend as much time considering the risks associated with a potential equity investment as I do the potential return. Both are unknowns in the investing process, but risk is the one factor that you can try to mitigate as you manage your portfolio of holdings.
Investment risk is always high in the stock market for the simple reason that equity securities trade in a secondary market. Their value is derived by buyers and sellers who use all the information the marketplace has to offer. Stocks always have two kinds of risks for investors: individual company risk; and the risk inherent in changing market sentiment. Both these risks are entirely beyond your control as an individual shareholder and, because of this, your personal investment risk is always high.
Right now we have a stock market that’s trending higher based on the expectation of strong earnings results and a recovering economy. That’s the good news. However, ahead of us there are major headwinds in the form of inflation, sovereign debt, and a demographic shift that’s going to change the very nature of the consumer economy. It’s a lot for a long-term investor to deal with and it’s something we all have to be wary of as investors.
I feel confident that the right shoulder formation of the S&P 500 Index will be completed. This expectation is based on the broader market’s current valuation, the stability of current investor sentiment, and the outlook for solid corporate earnings this year. But, beyond 2011, the commodity price cycle is going to force higher interest rates to deal with price inflation, which I think is more pronounced in the economy than the numbers indicate. Add in the likelihood of country defaults in Europe and I can easily see a marketplace where investor confidence disappears.
We’re not in a bull market for stocks at this time; we’re in a Fed-induced re-inflation of the economy and the stock market. On balance, I think the action is working, but the “free” money won’t last much longer, because global markets won’t let it. This means that the business cycle is going to change and it will be a whole new ballgame for the stock market and investors.
I remain optimistic about the economy and the stock market. I also remain wary of the systemic risks we face going forward. You can’t have investment returns without incurring investment risk. The key is to manage both in a way that keeps you covered when the marketplace changes. Make no mistake; the two constants in the investment business are change and risk.