Oversold Bounce, Relative Risk, More Downside Potential

This is extremely important as a further advance of the "bull market" will be difficult until the trend of advancing versus declining issues reverses.

Since March, there has been little reward generally for investors. The good news is that, so far, stocks have held their ground exceptionally well given the weak economic reports and the overall earnings/profits picture.

Earlier this week I took a look at the "quality" of earnings and the question of whether valuations are actually "higher" than currently stated. To wit:

"It is worth noting that until financial engineering took hold in 1990, the economy grew faster than wages/profits. Since 2000, the wages/profits ratio has become detached from all reality."

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This detachment leads to another problem that is arising for investors - valuations.

There is some truth to the argument that "this time is different." The accounting mechanizations that have been implemented over the last five years, particularly due to the repeal of FASB Rule 157 which eliminated "mark-to-market" accounting, have allowed an ever increasing number of firms to "game" earnings season for their own benefit. Such gimmickry has suppressed valuation measures far below levels they would be otherwise."

The reason I reiterate this point is due to a note from John Hussman discussing the "cheapness of stocks relative to bonds."

I'll repeat what I've called the Iron Law of Valuation: every security is a claim on a very long-term stream of future cash flows that will be delivered into the hands of investors over time. Given that expected stream of future cash flows, the current price of the security moves opposite to the expected future return on that security. The value of a share of stock is determined by far more than current earnings, and one's estimate of value will be ill-formed if current earnings aren't a sufficient statistic for the long-term earnings trajectory.

Moreover, market valuations, prospective equity returns, and actual realized equity returns have historically been only weakly related to the level of interest rates (even long-term interest rates). The long-term rate of return priced into stocks is far less correlated and less sensitive to interest rates than investors seem to believe.

Read: "Fallacy Of The Fed Model" For Additional Information

"But aren't stocks "cheap relative to bonds"? Unfortunately, the evidence suggests exactly the opposite. Indeed, despite a yield to maturity of hardly more than 2% annually, Treasury bonds are still likely to outperform the total return of the S&P 500 over the coming decade. The following chart presents the difference between the estimated 10-year total return of the S&P 500 and the yield-to-maturity on 10-year Treasury bonds, compared with the actual subsequent return of the S&P 500 in excess of 10-year bond yields. We estimate that from current valuations, the S&P 500 will underperform Treasury bonds by more than 2% annually over the coming decade. We've never observed a similar level of stock vs. bond valuations without stocks actually underperforming bonds over the subsequent 10-year period. Next, look at bear market lows such as 2009, 2002, 1990, 1987, 1982, 1978, and 1974, and recognize that the completion of every market cycle in history has provided better investment opportunities, both in absolute terms, and relative to bonds, than are presently available. Frankly, history suggests that a rather ordinary completion to the present market cycle would involve the S&P 500 losing more than half of its value."