Caution: This rally is out of hand

By The Wall Street Journal

Don't be happy; worry.

The Dow Jones Industrial Average is up 46% since March 9, when the world itself seemed to be coming to an end. In the entire 113-year history of the Dow, only six rebounds have been bigger and faster. But the swiftness and magnitude of this bounce-back aren't reasons to be cheerful; they are reasons to be cautious.

In March, stocks traded as low as 11.7 times their average earnings over the previous 10 years, adjusted for inflation, according to finance professor Robert Shiller of Yale University. That put the market at its lowest valuation since January 1986.

Today, however, stocks are selling at 18.4 times Shiller's measure of earnings. That isn't only up hugely from March, it’s also above the long-term average of 16.3 times earnings.

Robert Rodriguez, chief executive of First Pacific Advisors in Los Angeles, says that in March, investors feared getting crushed in a further decline. Now all they seem afraid of is missing an even greater rally.

Rodriguez is convinced that the consensus -- economic recovery by early next year at the latest -- is wrong. "People are talking about whether the shape of the recovery will be a 'V' or a 'W' or even a 'square root,' " he says, "but I think we are in what I call a 'caterpillar economy.' It will be up and then down, up and then down. We will be far from normal for a very long period of time. People deploying capital will end up destroying capital."

Insiders are now selling

I am not as worried as Rodriguez, but it is at times like these, when a rising market sweeps our spirits up with it, that investors need to evaluate their emotions and consider whether their beliefs and actions are justified.

In August, corporate insiders -- officers and directors of public companies -- sold nearly 31 times as much stock as they bought. From last September through March, in the depths of the bear market, that ratio was just 2-to-1, according to TrimTabs Investment Research of Sausalito, Calif. The long-term average is about 7-to-1.

Video: What the charts say about the rally thus far

The people who run companies don't know exactly what the future holds, but they do know more about their own companies than outsiders do. If they are furiously selling, how eagerly should the rest of us be buying?

Chasing the past

It is well-known that investors chase past performance, buying whatever has just made the most money for other people. What isn't commonly understood is that investors also chase their own past performance, buying more of whatever they themselves have made the most money on.

Research by economist David Laibson of Harvard University shows that 401k participants tend to add significantly to whichever funds they already own that have gone up the most. "Investors expect that assets on which they personally experienced past rewards will be rewarding in the future, regardless of whether such a belief is logically justified," Laibson says.

Continued: Don't run this yellow light

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