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As Market Rally Continues, Risk-Reward Picture Gets Worse

3 June 2009 2 Comments

We have had an insane run in the last 2 months.  The market has rallied over 30% from the March lows in just a matter of a few months.  For those that missed the run, I urge extreme caution in buying into the market at current levels.  The reason?  Risk/Reward!

As the market goes higher, the valuations increase.  Some sectors like Technology and Retail have valuations that are just out of control in my opinion, especially when you factor in a weak economy.  Now, just because the valuations are high, and I don’t recommend buying them, does not mean I don’t believe these are great companies.  I think that Amazon (AMZN) is one of the best companies out there.  It’s just overpriced, and when it comes to trading/investing, price and valuation matters.

Take a look at some of the following stocks:

STOCK 52-Week Low % Increase From Low Current P/E
Amazon (AMZN) $34.68 145% 54
Williams-Sonoma (WSM) $4.35 212% 48

Again, there are plenty of stocks with similar characteristics in today’s market. The run has been large. The economy is still weak. Proceed with caution.

As the valuations increase to high levels, the risk-reward picture gets much worse.  Simply put, your upside is much more limited and your downside is arguably higher.

Now, I’m not trying to convince you to be bearish on the stock market.  I’m telling you to be careful chasing a rally especially in the hot sectors like tech and retail.  It’s hard to justify a very high P/E in a struggling economy with still very real and present issues such as housing, the consumer and unemployment.  If you are dying to own these stocks, just be patient and wait for a better opportunity.

Interestingly, I would bet that many people are much more willing to invest at current levels than back in March when we were 30% lower.  Why?  Because, individual investors are incredibly swayed by overall market sentiment and the sentiment is very positive right now.  Unfortunately, you missed the way better time to invest when the sentiment was much worse.  That requires more discipline and expertise, which most individual investors probably lack.

I’m always very wary of buying in when the sentiment is so positive.  The easy money has been made.  This doesn’t mean there is not more money to be made as the rally continues, but realize that the risk is likely increasing in tandem.

2 Comments »

  • philip said:

    Honestly with the rally that we have had I am worried it will crash back down. It just feels like it has gone up to quickly again. I really don’t know enough to be a true judge of this but I am tempted to move some to safer funds for a while. Guess I really should have some plans not jsut do it when I feel like it.