"Why aren’t you more bullish?" That is a question that we have heard from a number of clients recently. For a variety of reasons, though primarily because of strong corporate earnings in recent quarters, they wonder why we are not taking on more risk in their portfolios.

"Why aren’t you more bearish?" At the same time, another set of clients, albeit a smaller one at present, are asking why aren’t we more defensive given the litany of woes threatening the stock market, including the twin deficits, geopolitical risks, rising energy prices and a vulnerable dollar -- to list just a few reasons.

In a very real sense, if our current stance is causing investors from both bullish and bearish camps to question us, that alone would make me think we are striking the right balance. But let’s take a look at how we go about formulating our approach to the market.

Reviewing The "Five Factors"
One of the primary tools we use to give structure to our thinking about the stock market is our "Five Factor Equity Model". Each month, we examine the latest data behind five important drivers of stock prices: Earnings, Valuations, Interest Rates, Sentiment and Liquidity. Based on our "reading" of the data, we place each factor along a spectrum of favorable, neutral or unfavorable for stocks.

Let’s examine where the five factors stand today.

Earnings
Corporate earnings have been incredibly strong for an extended period with the latest quarter (4th quarter of 2004) posting yet another 20%-plus increase over the same quarter a year ago. This is nearly three times the historical average of around 7%. And this comes on top of the fourth quarter of 2003’s nearly 30% gain over the 4th quarter of 2002. Earnings must be a big positive for stocks then, right? Well, not so fast. We must remember that the market is always looking ahead, so it's the expectation of future earnings growth, not a "reward" forhistorical earnings growth, that really drives stock prices. So, with earnings this good, how much better could they get? Moreover, as with many market factors, it's not just the absolute level that is critical, but also the trend that is important (arguably even more so). In the case of earnings, while growth is still very high, the rate of growth is decelerating. That may sound like a fine line, but to the stock market, that fine line is actually a demilitarized zone between good and bad stock market performance.

Valuations
No matter how solid a stock’s earnings picture may be, if you pay too much for those future earnings, it can be difficult to make money. As shown in the chart below, while stock valuations have come down from the extreme highs of a few years ago, and are now within a respectable distance of historical averages, they are still above average. And the recent trend is toward stable or rising P/E’s rather than further declines toward fair value. The price/earnings ratio using trailing 12-month earnings is now 20x; compared to 50-year average of 17x and longer-term average of 16x. Generally speaking, bull markets begin with valuations that are well below-average, not slightly above average.

Stock Valuations Are Still Expensive

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Interest Rates
One very clear supportive factor for the stock market in recent years has been interest rates. In the grand scheme of things, the overall interest rate picture remains friendly to the stock market and takes a bit of the bite out of the high valuation argument (in other words, when interest rates are lower than normal, valuations are usually higher than normal).

That said, the interest rate environment is much more complex than just some overall observation that rates are low. We need to consider the relationships between shorter-term and longer-term rates (the yield curve); the relationships between government and corporate bond yields (yield spreads); and the level of nominal rates (the yield that you receive) versus the level of real interest rates (the yield that you receive after subtracting inflation). And once again, there are the absolute levels of all these variables as well as the trends in those levels to monitor. Each of these has a message regarding the economy and the markets. Adding all of these factors up -- you will have to trust us on this so we don't spill too much more ink on the topic -- the overall interest rate environment remains mixed at best, to deteriorating and vulnerable at worst.

Sentiment
Investor sentiment (i.e., their outlook for the stock market) remains stubbornly bullish and complacent. While shorter-term market optimism has been bumpy in recent months, investors’ longer-term outlook remains quite upbeat. This bullishness is a contrary indicator (i.e. bearish for the market) and complacency is even worse. Investors are simply of the notion that nothing can go significantly wrong. Every investment can be boiled down to two fundamental factors: the potential for gain and the potential for loss.

At present, most investors seem to be viewing investments through only one side of the equation: "how much can I make?" There seems to be little if any concern for risk. This is demonstrated by the fact that individual investors currently hold a historically low level of cash and cash equivalents. The common rationale for this lack of cash is that investors "want to put the money to work" given the low return on cash compared to investments that offer higher potential returns. True, but cash offers 2% yields (and given that the Fed is still raising rates, that yield is going higher), with effectively a zero percent change of loss. What is the stock marke's chance of loss? Well the average decline in the stock market during a recession is nearly 50% (43% actually -- the last two recessions were not typical in that they were among the shallowest on record). Remember a 50% loss requires a 100% return to get back to even. Most investors don't appreciate these points enough and especially in light of the concerns that we have listed so far.

Liquidity
Liquidity is essentially a measure of how much money is available to be funneled into investments. We just mentioned the low level of cash in individuals’ portfolios so there isn’t much available there. Mutual funds are similarly at historically low cash levels. Where will new buying power in the stock market come from? One answer -- and this is an unequivocal positive for the market -- is that corporate balance sheets are chock-full of cash. And companies continue to generate more cash from operations than they are investing back into their businesses, so cash stockpiles are growing. This will likely translate into more stock buy-backs, higher dividends, and increased merger and acquisition activity -- all strong pluses for the stock market. An offset to this, however, is the expectation that the government will likely be removing liquidity from the economy (primarily by reducing government spending) now that the election is over and the economy is on firmer ground.

What Does It All Add Up To?
If you add up all the pluses and minuses of the five factors, the overall market environment remains a decidedly mixed bag. So it’s really no surprise that we are "hearing it" from clients on both sides of the debate.

And it’s not just our clients that are of mixed minds; many investment professionals fall on different sides of the fence, as well. There are very plausible arguments for why the economy should take off and why it should falter; why we could see much higher inflation and why we could see deflation; why China will drive a strong global economy and why China is a "bubble" that will trigger a global recession; why the U.S. dollar will "collapse" and why it will remain the world’s reserve currency for many years to come, and on it goes.

And that is just the point. A lot of very bright, experienced professionals -- people who are right far more often than they are wrong -- will, in fact, turn out to have been wrong on how to approach today’s markets.

At Kobren Insight Management we recognize the fallibility of market forecasts. We may be confident (or perhaps presumptuous!) enough in our abilities to pick superior mutual funds over time and make more good investment decisions than bad. But we’re also humble enough to recognize that any one of our decisions could be incorrect. That is exactly why we think it remains prudent to build reasonably balanced and diversified portfolios. And given the particular uncertainties in the current environment, we also think it is prudent to keep those portfolios very close to their "neutral  allocations until a clearer signal on market direction emerges.

Thank you again for your confidence. As always I invite your questions or concerns.

Sincerely,