Upside Risk

When investors consider risk, it has traditionally meant downside losses.  The idea of profiting from a declining market, while commonplace for professionals, is relatively new to the average investor.  When trying to time the market by exiting or by buying an inverse ETF, the concept of risk has changed.

You must now ask:  What is my upside risk?

I have highlighted a number of bearish concerns in recent weeks, noting that many pundits see little chance for the market to move higher.  If you believe that the upside is limited to a few percent, and that the market could revisit last year’s lows, your investment decision is easy.

Alternative Viewpoints

Bespoke Investment Group summarized (in a typically helpful table) the 2010 year-end targets for thirteen top strategists.  The average was 1232, more than 10% higher from current levels.  Four of the thirteen have a target of 1300 or higher, a gain of over 20% for the year.

Jim Paulsen of Wells Capital Management earns the highest accolade in our office.  When he appears on TV, we turn off the “mute” button and scroll back the TIVO!  He has a rare and admirable combination.  He is both a “chief strategist” and a real economist, a refreshing change in an era where so many noisy experts seem to have learned economics from Cliff Notes or by reading a blog.  Paulsen was featured in a Barron’s interview last week.  Here are some high spots:

• He sees the S&P 500 reaching 1350 as a “reasonable possibility” during this year. 
• Investor sentiment is conditioned by the “great depression” scare of the last two years, and the recent correction.
• He sees expanding profits, “Companies have the greatest profit leverage that they’ve had in decades.”
• Valuations are attractive — P/E at 11 times next year’s forecasts, and inflation at a low point.
• Debt is high, but it is unfair to judge at a low point in GDP.

There is a lot of merit in these arguments, which Barron’s cites as “unique in …optimism for the economy and stocks.”

Actually, these arguments are not unique.  They just do not get much exposure in Barron’s!  Regular readers know that I expect the market to reach pre-Lehman levels as an initial target, justified by current economic progress and earnings.  So do most of those in the Bespoke survey.  We could all be wrong, but it still bears watching.

Conclusion

Since recent market indicators have been worrisome, it is natural to scale back your long positions.  The key question then becomes one of upside risk.

It is time to be vigilant — cutting through the political commentary and looking for solid evidence about economic progress and corporate earnings.