The problem with the contrarian approach to investing is that it works best when investor sentiment reaches extreme levels, such as panic or euphoria.  It is not as useful when the majority of investors are somewhat worried or complacent, as they are today.
 

This is why, to fine-tune our discipline, we try to use both a contrarian and a value approach, a combination that we have creatively labeled “contrarian value.”  Most of the time the two approaches should go pretty well hand-in hand:  The nature of a market is that when investors become excessively pessimistic, the price of assets like stocks should become excessively cheap.  When investors become excessively optimistic, asset prices should become excessively expensive.  The problem lies in defining “excessively.”
 

The simplest measure of a stock’s low or high relative cost is the Price-to-Earnings (P/E) ratio.  As can be seen from the Bloomberg chart below, the P/E ratio of the U.S. stock market, as measured by the S&P 500 index, has fluctuated from a historically low range of 7 to 10 between 1974 and 1983 to an unprecedented high of 30 in 1999.  At this writing, it has corrected the gross overvaluation that prevailed at that peak, but only by returning toward 16 – roughly the middle of its very long-term historical range.
 

 

As it happens, the massive expansion in the P/E ratio that characterized the big bull market in stocks between 1982 and 1999 corresponded almost precisely with a spectacular bull market in bonds.  This is not surprising, since bond prices and stocks’ P/E ratios normally rise when bond yields decline, and the chart below depicts the collapse in bond yields since 1981.
 

 

What is somewhat more puzzling is that, after 1999, interest rates continued to trend down but, instead of recovering, since the two usually move in inverse fashion, P/E ratios came down as well.
 

A number of observers believe that the reason is the active manipulation of interest rates in recent years by central banks in general, and the Federal Reserve in particular.
 

Indeed, several central banks embarked upon a policy of “quantitative easing,” basically announcing that they would keep adding to the money supply no matter how low that would drive interest rates – even below the rate of inflation, if necessary – to force economic recoveries (my interpretation, but borne out by the facts).  Without quantitative easing, many believe, interest rates would already have recovered, perhaps significantly, to reflect their historical premium over inflation.  Interestingly, when Fed Chairman Bernanke recently gave indication that quantitative easing might progressively be wound down, interest rates spiked up noticeably.
 

For many traditional investors, the sequence of events is fairly simple:
 

• Aggressive monetary expansion by the central bank eventually triggers price  inflation because a fast-increasing supply of money chases a slower-increasing supply of goods;
   
• Inflation necessitates an increase in interest rates, to compensate savers for the erosion in the purchasing power of their savings that it causes;
   
• Since interest rates on bonds compete with the return on common stocks to attract savers’ capital, higher interest rates require a higher Earnings Yield -- or its inverse, a lower P/E ratio -- on the stock market.
   

For these traditional investors, the promise by the Federal Reserve in September 2012 of an open-ended policy of quantitative easing was the guarantee that the post-crisis financial episode would end in tears, when monetary easing became less unconditional and liquidity was thus withdrawn from artificially inflated financial markets.  Those investors have been waiting for the day of reckoning ever since.
 

The situation today can be summarized as follows:
 

• The U.S. economy, while still fragile, has been experiencing an unmistakable recovery; many other major economies, while lagging behind, may be in the process of bottoming out.  China and some other emerging economies may be in the midst of structural change or adjustment, but their growth should continue to trend at above-average rates.
   
• Sooner or later, the recovering real economies will absorb more of the liquidity available globally (for spending and investment), leaving less of it for the financial markets.  Interest rates should rise again, perhaps strongly if central banks also decide to become less “easy.”
   
• This has not been totally overlooked by the stock markets, which, these days, have a tendency to yawn at good economic news but rally on weak information.  The logic is that strong news carries the threat of a tighter monetary policy, while weak news promises a prolongation of quantitative easing.  However, this strikes me less as a convincing logic than as a dangerous addiction to monetary ease.
   
• Thus, the likely consequence of recovering economies and rising interest rates will be downward pressure on P/E ratios.
   

Under such a scenario, the only thing that could propel the stock market higher would be strong gains in corporate earnings. But corporate profit margins are generally high – in fact, at a record level in the United States. With stronger economies, both wages and commodities prices should tend to rise, and so it seems unrealistic to expect major gains in profit margins.
 

As I have pointed out in the past, making investment decisions is not a popularity contest:  It is not about being right or wrong about a stock or a market; it is about how much money you stand to make if you are right and also, just as importantly, how much you stand to lose if you are wrong.
 

Today, at current valuations, it seems to me that the odds of making large gains on the broad U.S. stock market do not compensate adequately for the risk of loss.  In most foreign markets, the upside potential seems somewhat better from generally lower earnings and better valuations.  But significant economic uncertainties remain, so that the risk/reward ratios are not necessarily much more attractive, at least for the moment.
 

Despite the scarcity of compelling macro opportunities, it remains worthwhile to look for compelling individual ideas, which always exist somewhere.
 

I recently had the opportunity to speak in front of a group of Chinese entrepreneurs about professional investing.  A question was asked why, when we hold large cash balances and effect few transactions, they should still pay us.  I answered that periods like this are when we work the hardest to uncover the next winning ideas.  Perhaps this is when they should pay us even more?
 

So far, that argument has not worked with Western or Japanese investors.  But hope springs eternal…
 
 
 

Disclosure: This article reflects the views of the author as of the date or dates cited and may change at any time. The information should not be construed as investment advice. No representation is made concerning the accuracy of cited data, nor is there any guarantee that any projection, forecast or opinion will be realized.