Over the last month, my conversations (casual and business) have yielded an overwhelming consensus about the market.  The consensus is that we are headed for a meltdown in the financial sector, high oil prices are here to stay, and it's too early to put any new money into the market.  A client summarized it nicely yesterday when he said, "I'm totally spooked by the market."

For the most part, I don't have any argument with this view.  The economy is going to get worse before it gets better, and there are still skeletons in the Wall Street closets.  The fact that the U.S. government is bailing out banks (Bear Stearns, IndyMac) and the SEC is interfering with the capital markets by selectively  preventing (naked) shorting on 17 financial institutions, tells us that we're well into a financial crisis.  

I'm not, however, in the 'high oil forever' camp.  I think the price will ultimately reflect the economic slowdown and the meaningful changes taking place on the demand side.  And I don't necessarily agree with the investing conclusion that comes out of the consensus view. 

In trying to predict the market, we not only have to get the outlook right, but we also have to determine how much of that outlook is already factored into stock prices, or baked into the cake as they say.  Dr. Sandy Nairn, the founder of Edinburgh Partners (EPL), makes that point in a special letter to clients this month.  He wrote, "The key question, as always, refers to the profile of future profit growth relative to what is already discounted by the market."  With regard to the slowdown he goes on to say, "One cannot draw the simple conclusion that those sectors most affected should not be owned."

Sandy is referring to the two necessary elements of the investment process – the fundamentals and the valuation (which includes investor sentiment). 

I want to use our Global Equity Fund, which Sandy's firm manages, to illustrate the two elements at work.  

EPL's outlook for most industry sectors continues to be subdued.  Their profit forecasts reflect a continuation of recessionary conditions (fundamentals).  

There are parts of the market, however, where they think the outlook is more than factored into the stock prices (valuation).  For example, about 15% of the fund is in financials, which is where they think the greatest opportunity lies, although the risk is still high.  Valuations are attractive, even after assuming more writedowns and dilutive capital raising.  In other words, investors are being amply paid to take the risk and when things stabilize, the stocks will bounce back dramatically.

As an aside, it is the financials that have caused the fund the most grief over the last year. While EPL was expecting the economy to weaken, it underestimated the impact that the sub-prime meltdown and subsequent credit crisis would have on the banks and insurers (fundamentals).  While they did adjust quickly to the new reality, they subsequently made another misstep by incorrectly reading how much of the bad news was factored into the prices (valuation).  The stocks dropped further on announcements that EPL was for the most part expecting.

Looking forward again, EPL is balancing off the financials by investing 40% of the fund in the more conservative telecoms and pharmaceuticals.  For most of these companies, the outlook for profits is "dull" (fundamentals), but the dividends are substantial and look to be secure.  In other words, the outlook isn't exciting, but the market isn't expecting much either (valuation).

Technology and energy stocks account for about a quarter of the fund.  The outlook for energy companies, even at lower oil prices, is very good (fundamentals), but the stocks are the most expensive ones on the list (valuation).  EPL's bias is to reduce the energy holdings.

We are all uneasy about what's going on right now.  Our capitalist system, at least the U.S. version, is being put to the test.  The consensus view may prove to be right, or heaven forbid, too optimistic.  But as investors, we have to make sure we consider both elements of the investment process.  The market is a discounting mechanism.  It looks forward.  That is why the best opportunities come out of the gloomiest periods.

I'm not yet mortgaging my house to buy the market.  A gloomy outlook is only one of the necessary ingredients for a good buying opportunity.  But I am cautiously nibbling at the odd stock and adding to the parts of my portfolio that are down and out (global equities specifically).