Stocks were very strong in October, with the Dow and S&P500 up just over 5% for the month. The Russell 2000 index of small cap stocks and the Nasdaq continued their steep ascent, up 8.4% and 8.13% respectively. Bonds fell a bit as rates rose on news of a sharply recovering economy (strong economic data is the sort of news that makes investors worry about inflation and the Federal Reserve raising interest rates, both of which can hurt bond values). The Lehman Long Term Treasury Bond Index was down 2.8%.

Our Powerfund Portfolio lead article from October 15th 2002 was written during what was a difficult period for investors. On October 9th of 2002 the Dow had fallen to 7,286. We laid out the case for stocks being a relatively good place to put your money at current valuations. 

Coincidentally, October 9th was the end of the great bear market that started on March 24th of 2000. While the market came close to slipping below that October low in March of this year, today we are solidly above levels hit in those dark days.

In fact, we’re a little too solidly above those levels. Recently the Dow was flirting with 10,000, a near 40% increase from those October ’02 lows. Investor’s euphoria is even more exuberant for smaller cap and tech stocks. The Nasdaq hit a low of 1,110 on October 10th (down from an all-time high of over 5,000 – ouch) and almost hit 2,000 in early November – a whopping 80% gain. 

Stocks are a great place to be when emerging from a bear market, and small cap stocks are usually even better performers as an economy recovers and we start a new bull run. Or so the story goes. 

While this pattern is historically true, it is not law. Coming out of past bear markets stocks have generally cheaper than they were at the current bear market end. In bear markets of yesteryear, smaller cap stocks were cheaper still, as investors fled questionable and risky small names. 

This recent bear market never really hurt small cap stocks at all (one reason for their relative strength is that small cap stocks never became as over overpriced as their larger cap counterparts), but investors are still buying small cap at the end of this bull market simply because small caps are supposed to beat the market coming out of a recession. 

Watch out for such market truths. They have a way of lying to you. 

Hoping for the past to repeat itself is one problem in today’s market. Another is optimism. There is now a general sensation that the Nasdaq is on its way back to 5,000, so you should get in now. We also think the Nasdaq is heading back to 5,000. But we don’t think its going to get there until round 2010. 

Economic growth going into this new business cycle will likely prove weaker than previous cycles. For one, the recession we just experienced was relatively mild; if the swing down was soft, we can expect the swing up to be subdued also. Additionally, we have ongoing war related costs, and a huge debt load facing federal and state governments, corporations, and consumers to tend with. The debt servicing costs will weigh on future growth like a runner in wet overalls.

These are not times for boundless optimism and buy at any price investing. In recent months investors (not to mention many analysts and gurus) started regaining confidence in the stock market. Recent performance is the glow that attracts investors like bugs to lights at night. Unfortunately, some of the lights are bug zappers, and investors may get burned.

In fact investors should probably think about easing up on stocks, particularly hot smaller cap and tech names. We own some of these hot properties in our model portfolios - the exciting funds up big time over the last year that investors are now flocking too. Many of our aggressive picks in our portfolios are up over 40% in the last year, one is even up 80% - these are funds to lower exposure to, not to build new large positions in.

These big performance numbers concern us and should concern you. Entire groups of stocks can’t continue to make gains like this– they simply were not cheap enough to start with and the likely earnings growth going forward is simply not strong enough to rationalize the high prices.

Thirteen months ago we laid out the case why stocks were priced attractively relative to other asset classes. Back then the 10 year Treasury bond paid around 3.5%, while the dividend yield on the S&P500 was around 2%. This is no longer the case. Today the S&P500 has a dividend yield closer to 1.5% and the 10 year Treasury bond was recently yielding closer to 4.5% (although it has come down a bit lately). Even using optimistic earnings estimates for the S&P500, the market is trading at around 20 times earnings. At some point next year you will be able to buy a lower risk asset, the 10 year government bond, with a similar earnings yield as the market, because a $1,000 investment will yield 5%. A Safe 5% is preferable to a risky 6%.

At these levels we are at fair value, if not more than fair value. If and when the fed raises rates and the 10 year bond goes back over 5% in yield, it will be very difficult for a stock investor to beat that return by much going forward, unless stocks fall in price. This does not mean stocks should be completely avoided, but, as we have done in our newsletter portfolios, you investors shouldn’t overweight allocations to equities in their own portfolios. Investors should overweight asset classes that are attractively priced. Stocks are not attractively priced. Tech and small cap growth stocks are actually overpriced today, and should be underweight.

This next year is going to be a tough one for investors. It is likely short term bonds and cash will be some of the top categories of funds over the next year. The good news is that except for certain tech and growth stocks, we are not in dangerous waters valuation-wise like we were in early 2000. Pullbacks will likely be less than 20% from these recent highs - not massive 50%+ bear markets. However, if safe government bonds start yielding say 5.5% or more, and the stock market goes up another 20%, look for a precipitous fall.