Happy Autumnal Equinox!

Today is the day when people in the Northern Hemisphere celebrate (if that is indeed the right word), the end of summer and the beginning of autumn. This equinox brings a feeling of transition as we move from one season to another; a sense of motion as we move from one place to another. It also brings with it a sense of balance, as we experience on this day the same amount of day and night, dark and light. Many cultures have a strong tradition of a harvest festival, and often these celebrations coincide with the Autumnal Equinox. Even Wiccans and other neo-pagans hold the day in high regard.

As I reflect on this day of transition, this day of balance, this day of harvest, I wonder if all those people telling me to take some profits may be on to something. After all, the market has rallied over 50% since early March, and some people tell me this is the biggest rally in this short period of time since the 1970s. Before that, one would have to look back to the 1930s for this kind of strength. The negative case for the market still carries sizable weight – weak economy, weak U.S. dollar, growing government deficits, high unemployment, unending series of bank failures, fear of rising inflation, financial scandals, key industries on government life support, and so on. Why should the stock market be going up with all this bad news out there?

I think measuring the market’s performance from its crisis low may be misleading. First of all, there’s the math involved. If a stock falls 30%, say from $100 to $70, it needs to rise 42.9% to get back to $100 (do the math). So a rally that simply brings the market back to its starting place will appear “bigger” than the preceding decline. Second, the price of a stock is actually the result of a very complex series of decisions, measurements, and calculations made by a large number of (usually) very smart people. Although it looks like a simple number, it represents so much more. When a stock moves from one price to another, it does so driven by net result of all kinds of investors trading the stock for all kinds of reasons. Although we can simply measure the distance between the two points, this number tells us very little about why the stock moved to where it is and probably tells us nothing about where it is going.

In my experience, three key factors impact stock prices – earnings, interest rates and sentiment. Earnings can be affected by the economy, but excellence in execution and/or good fortune can often be more important. That said, an improving economy is usually good for earnings. The level and direction of interest rates affects valuation and influences investor choices. When rates are high, stock valuations tend to be low and visa versa. Generally, falling interest rates are good for valuations, but rising rates (if accompanied by strong economic growth) does not necessarily hurt the stock market. Sentiment, in my view, is usually a contrarian indicator; that is, when everyone is bullish, the market is near a top and when bearishness reigns, a bottom is at hand (reflect for a moment how bullish you were in early March of this year…)

So where do we stand now on these three factors? The economy is improving – consensus expects positive GDP in the third quarter. A majority of companies are raising expectations for the balance of 2009 and 2010. Earnings = Big positive. Interest rates are very, very low, and although some fear higher rates in the future, I would argue that they would have to rise a lot from here to significantly impact stock valuations. Interest Rates = Positive. Despite the rally, sentiment remains mixed to bearish. We have not yet seen the retail investor plow back into the market. Trillions of dollars still remain on the sidelines in “safe” money market funds. Sentiment = Positive.

I don’t make predictions (I used to do it professionally), but it would be very unusual for the stock market to enter another bear phase now with ALL of the important determinants of share prices so clearly in positive territory. Pauses and corrections are the norm for any near bull market and I would not be surprised to see them sometime down the road. Yet, I think anyone trying to wait for a big pull back to get back into the market might be disappointed.

Instead of looking to harvest some profits here, investors may want to consider the possibility of a new transition – from a bear market rebound into a new, real bull market. Maybe we are only half way into this move upward, the balance of which could take us up another 300 points+ on the S&P 500…