For well over a year now, the economy’s been recovering, the stock market’s been recovering, confidence has been rising, and the perception of risk in the stock market has been dropping at a rapid rate.  Just look at the VIX (the volatility index), or the price paid for options.  It’s dropped over 80% since the fall of 2008.  Money’s begun flowing back into the stock market.  If you’re in cash, you’re an idiot (not really but that’s how they want you to feel).  The pressure to own stocks has been extremely high.

A couple of weeks ago, Goldman Sachs (GS) got hit with a lawsuit from the SEC.  The market fell but bounced right back up like a championship fighter getting a cut and shaking it off.  But, the combination of Goldman Sachs testifying and getting grilled by Congress, Ben Bernanke saying our deficits could mean higher taxes, interest rates, & lower benefits, and Greece & Portugal’s debt being downgraded was too much.  The Dow Jones was down over 200 points (the biggest point drop since January) and volatility index spiked up over 30% on Tuesday.  It was like the market had been in a trance and someone snapped their fingers in front of its eyes.  Oh yeah, stocks do have risk.  They can go down.  It’s amazing how sentiment can change so fast.  The world felt like it was ending on Tuesday.  It’s not ending but we could have a meaningful correction.  After all, there hasn’t been a 10% correction in the indices since the rally started in March of 2009.  Is this normal?  Partially.

After a major collapse and recession like we had in 2008, it’s common for the Federal Reserve to pump money in the system and “put America back to work”.  With that comes a rebound not only in the economy but the stock market.  We’ve had plenty of rebounds over the last 100 years.    This one isn’t necessarily longer than most (over one year now) but the trajectory of the recovery has been amazing.  The persistent buying has been rather remarkable.  It’s akin to the late 1990s bull market.  Stocks aren’t necessarily as expensive as they were then, but I don’t think they’re dirt cheap either.  In fact, when looking at how expensive stocks are measured by the P/E ratio of the S&P 500, investors are still paying less and less for stocks.  This is a common trend where investors will continually pay up for stocks for several years and that is followed by several years of investors wanting a better deal.  Instead of looking at the P/E ratio on a daily basis, below is a 10-year moving average of the P/E ratio on the S&P.  Before you send me e-mails about how P/E ratios don’t really matter.  I’ll agree that it’s not the end all be all of valuating a company or the stock market.  But, it’s one metric and its part of the overall equation.

You’ll notice that investors had a big headwind during the 1970s because while stocks went up and down, the P/E ratio continually pushed lower making it difficult to buy and hold stocks and see them appreciate.  The 1980s and 1990s were just the opposite.  Not only were corporate profits rising, but investors were more willing to assume risk and pay more for those profits.  However, after peaking around 23 or so in 2002, the 10-year moving average P/E ratio on the S&P 500 has been falling and is now down to 19.  It would not surprise me if this continues to fall over the next several years based on history.

The point of showing you this is not to assume you won’t make money in stocks but to show you how valuations do matter over a long period of time and it’s like a freight train.  Once it starts moving in one direction, it’s hard to slow it down.  Combine that with higher tax rates and potentially higher interest rates, and it could be an interesting decade for stocks.  One that begs we pay attention and don’t assume.  Those are the longer term challenges.

Getting back to the current market action, the lack of a correction doesn’t guarantee one.  I’ve heard the argument for lack of volume for over 12 months.  I’ve heard the argument that it’s been XX days since a correction, therefore we have to have one.  Does it feel like we’re due for one?  Sure.  In fact, it seems like everyone is now agreeing on the same story.  The economy’s recovering, we’re due for a correction, and once we have that minor correction, we’re off to the races again.  Heck, I agree with that, which is where the contrarian in me comes out.  Everybody agreeing with each other does concern me.  However, instead of getting into the psychological games with myself, I’ll rely on the same several indicators that have helped me make money during this run.  I can still see that there is more demand for stocks and less supply overall.  That points to higher prices over the medium term.  If you’re holding some cash, continue to average in which I’ve been advocate of for several weeks.  If you’re 100% invested, cull out weak stocks and sectors and take profits on specific positions.  We are still overbought in the very short-term and I certainly don’t have a problem with those wanting to short for hedging purposes or a trade, but I think hanging on to shorts too long might be a losing battle.

All day long, my screen flashes takeover rumors, earnings releases, downgrades, upgrades, mergers, IPOs and everything else you can imagine.  There’s never a shortage of information flowing.  Today, I saw that Goldman Sachs was being sued by the SEC.  I reported it on my twitter within seconds of the news breaking.  Down the stock went.  Even though Goldman didn’t finish at its lows, the damage was still pretty bad.  The stock was down $24 and almost 13% Friday alone.

Above is the picture of the carnage.  I don’t need to point out when the news broke.  It was fast and furious.  Most of the money was lost (or made depending on what side of the trade you were on) within just a few minutes.  I hold no position in Goldman Sachs but many of you do whether you know it or not.  This is one of those companies that many many mutual funds own.  It’s a staple.  If you own some financials, you probably own Goldman.

But, this picture and this drop today reiterates why we need to diversify.  I almost hate writing that word, “diversify”.  It sounds so much like the insurance salesman in the 1980s or 1990s telling his “prospects”  to spread out and diversify.  But, really, most people didn’t learn how diversified they WEREN’T until 2008 when the market crashed.    Diversification doesn’t mean buying big baskets of essentially the same thing.  It means owning some securities that move completely different from each other.  The idea isn’t to have one thing going up while the other is going down.  There’s no point in that.  But, we do need to have some rainy day money, some money that pays us monthly cash flow, and some money that doesn’t require somebody else down the road to pay more for our asset so we make money.

I still meet people everyday that still have most of their net worth tied up in securities that are basically the same thing.  The market goes up, they make money.  The market goes down, they lose money.  There are other things to do with your money besides just stocks  and mutual funds.

Nobody woke up this morning knowing Goldman Sachs would drop $24 and take the whole market down with it.  But, it reminds me why we own baskets of securities sometimes instead of just one company.  I know people that are loading up on Apple because of the Ipad.  It’s been on a roll and yes, I love the company (although I think it’ll drop in the short-term).  But, these people are taking huge chunks of their overall investment portfolio and speculating.  Yes,  it’s speculating.  It’s speculating because of the amount of their  portfolio they own.  Not because the company is no good.  We don’t know Apple isn’t cheating on their books or Steve Jobs is healthy just like we didn’t know Goldman was going to be sued today.  This was a black swan event (go read the book).  What we don’t know is what can hurt our portfolios.  All financials fell today but the basket was down about 3.5% while Goldman was down almost 14%.

I like individual stocks just like the next guy but today was a reminder why we diversify.

Right now, everyone’s partying and the confidence continues to build which is making me more nervous.  However, the internals don’t suggest a major decline anytime soon.  With that said, if we zoom out and begin to analyze what the next several years may look like instead of just the next several days or months, the 1960s and 1970s keep popping in my head.  Below is a picture of the Dow Jones from the spring of 1960 to the spring of 1980.

The first thing you’ll notice is the enormous rally of 75% from 1962 to 1965.  Look familiar?  But, those that thought they were back in a buy and hold environment were caught off guard.  Because that was immediately followed with a 21% decline in just about 9 months.  This back and forth went on for 20 years without any real appreciation.  That was a time of higher taxes, higher rates, and more inflation.  And, these weren’t just small moves.  The Dow Jones went up and down 20-70% during that time.  But, at the end of the 20 years, the market hadn’t appreciated very much.  In fact, it was down from 1964-1980.

So, we can enjoy this rally however long it goes.  But, just keep the big picture in mind.

Click here to listen to Through A Trader’s Eyes Podcast #17 – April 9, 2010

Even though natural gas prices have risen in the past few days.  The prices in 2010 continue to fall overall.  In fact, just in 2010, natural gas prices are down about 25%.  Since they peaked in July 2008, prices are down 69%!  On the other hand, oil prices have stabilized since their peak and have actually risen 8% in 2010.  This has many concerned that any economic recovery will be muted by rising oil & gasoline prices.  But, what about the investment side of this?  Surely, natural gas has to find a floor.

Looking at the picture below, you can see that oil is 20 times the price of natural gas.  Over the past 20 years, oil has averaged about 10 times the price of natural gas.  So, we are double that right now.  Besides the peak in 2009, this is the highest level since 1990 on this ratio.

There are all kinds of reasons why this ratio could stay high.  But, over the years, I’ve learned several things about markets and investments.  One of them is that when you see a ratio like this get way out of whack, it generally comes back into line at some point.  If you look at P/E ratios for example.  You know I’m not a big proponent of using P/E ratios to make money.  But, overall, investors were rationalizing for years why P/E ratios didn’t matter in the 1990s and early 2000s.  They did matter and stocks were simply too expensive.  That ratio came down and corrected.  I think the oil to gas ratio will come down at some point as well and the long-term play will be to short oil and go long natural gas.  I’ve also learned that sometimes these things take a while.  The safer play right now is going long pipeline companies and natural gas stocks, not the commodity.  But, we’ll certainly continue to watch this ratio.

Sometimes you’ll hear commentators say this economic data that is released doesn’t really matter in relation to the direction of the market.  On Friday, the non-farm payrolls report was released.  This, on a day when the equity markets were closed.  Futures were open so we saw some reaction to the numbers, but it was very muted.

Friday’s report shows that 162,000 jobs were added last month.  When we dissect the numbers, we notice that most of the jobs may be because of census hiring sand people hired that would have been hired the previous month had it not been for the bad weather.  In other words, it was a make up month.  Regardless of the reasons, we had more hiring last month than we’ve had in several months.  At the peak of the recession, there were almost 700,000 jobs being lost every month.  Now, it’s make up time and it’s going to take a lot more than 162,000 jobs per month to really get the economy in a stable and healthy situation.

The bottom line to the jobs report is that jobs do matter.  It is true that many indicators that are released are just noise and add to the vibration of the markets.  But, there are a few that really help you make money.  In fact, I’ve written about the GDP growth rate (or non-growth rate if you were looking at 2008 numbers) and how that number is very correlated to stocks.  Well, Friday’s release of jobs is another one you can count on.

What we notice from the picture above is the tight correlation between jobs and stock prices.  In green, we have the S&P 500 since 1999.  In blue is the amount of jobs being created or lost every month.  A couple of things stand  out.  First, the correlation.  Second, this is a “V” shaped recovery.  If I have to explain that one, take a second look at the picture.  As soon as the jobs losses each month began to decrease, the equity markets began to run.  And, they haven’t stopped.  Here’s the rub though.  In order for the equity markets to continue to appreciate at this rate, jobs have to be created at a better rate each month.  In other words, if 100,000 jobs are created each and every month for the next 6 months, the blue line will be moving sideways not up.  So, we need an increase in the number of jobs created.  This is similar to the rate of growth of our economy.  It’s fine that our economy is growing but is it accelerating?  That’s what investors key off.

These charts tell you the economy is still accelerating and jobs are being added at a faster rate.  As I’ve suggested in the past, I do believe these indicators will start to level out in the next few months and that could cause equity prices to begin to flat line.  So, we must be careful.  Jobs do matter.  The economic recovery does matter.  Earnings do matter.  Not every report should be ignored.

In the past couple of weeks, we’ve seen sellers becoming a little more active and buyers becoming less active.  This is something to watch.  The strategy for the remainder of 2010 will be to cull out weak stocks and sectors and continue to upgrade to the areas where money is flowing in at a fast rate. This is because the bull market that began over a year ago is maturing.  Don’t confuse that with ending.  It’s simply maturing.  That’s the stage when investors become a little more picky and take more profits.  Money doesn’t necessarily exit the markets but it simply rotates.

I continue to average in to the equity markets with any idle cash constantly being aware that we’re certainly due for a correction.  I know many of you are holding cash and feel paralyzed by this market.  It’s ok to invest but having an exit strategy is key.  There are some technical indicators I’m watching that have signaled red flags.  Therefore, cautiously optimistic is the name of the game in the short-term.  Over the medium term, I’m still bullish.

We’ll let the economists argue whether or not this recovery and these jobs numbers are “real” or just the government propping it up with artificial stimulus.  Meanwhile, I know when the blue line’s going up, the green one follows.

Have a great Easter everyone!

This post published at www.karleggerss.com

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