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3 Stock Market Lessons for the Rest of 2013

By Alex Dumortier, CFA - Apr 1, 2013 at 7:00PM

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Here's what we learned in the first quarter.

To begin the second quarter, stocks were unable to hang on to the new record high achieved last Thursday, at the S&P 500 (^GSPC -1.18%) fell 0.45% on the day, while the narrower, price-weighted Dow Jones Industrial Average (^DJI -0.21%) lost just 0.04%.

Reflecting the losses, the VIX (^VIX 4.21%), Wall Street's fear gauge, rose 7% to close at 13.58. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

The rest of the year starts now
Q1 is in the books, and it contains three interesting lessons for investors as we look out toward the rest of the year:

1. A euro is still a euro, except in Cyprus
The Cypriot debacle has taught us not only that the eurozone crisis is alive and well, but also that eurozone leaders haven't lost their touch when it comes to misjudging the market's attitude and to botched crisis management. That they initially approved a bailout package that had small depositors losing money beggars belief!

Bottom line: Cyprus, although economically insignificant, is the most recent, most glaring evidence of the internal contradictions that exist within the eurozone. Even if we were to rule out the possibility of the breakup of the euro, my base-case scenario for Europe is an extended (read: multiyear) period of economic stagnation, Japan-style (though probably not as severe). That's good neither for Europe nor the United States.

2. At age 4, this rally now looks sturdy on its feet
Stocks bottomed more than four years ago, on March 9, 2007. Since then, they've had a phenomenal run, with the S&P 500 up 131% so far. While it has suffered periodic corrections along the way, recently, it has shrugged off macroeconomic concerns with uncharacteristic ease, whether they be related to the "fiscal cliff" and other budgetary concerns or to Cyprus. Although I'm concerned that this bull market serves at the pleasure of the chairman of the Federal Reserve, its new resilience is chipping away at my skepticism and turning me into a believer. One element, however, is keeping me from becoming an unabashed convert.

3. Stocks still look expensive on long-term measures of value
With the S&P 500 trading at 22.7 times its cyclically adjusted earnings-per-share, stocks don't look cheap on this long-term measure of value (cyclically adjusted earnings are the average of trailing-10-year inflation-adjusted earnings). In fact, the current ratio is 38% higher than its long-term historical average. While this has no implications for stocks' short-term performance, this ratio is a good, though not infallible, indicator of long-term returns.

In summary: Significant risks remain, but I think the environment is favorable to stocks as investors' risk aversion continues to abate. However, for long-term success, you're best off focusing on stocks that still offer a margin safety, either directly, because the shares trade at a discount to their intrinsic value, or via the quality of the business franchise.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
^DJI
$31,812.01 (-0.21%) $-68.23
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
^GSPC
$3,926.71 (-1.18%) $-47.04
CBOE S&P 500 Volatility Index Stock Quote
CBOE S&P 500 Volatility Index
^VIX
$29.68 (4.21%) $1.20

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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