THE BLOG
05/28/2007 11:19 am ET | Updated May 25, 2011

The Lindsay Lohan Stock Market

Today's giddy stock market is as grounded as Lindsay Lohan on Sunset Boulevard at 4 a.m. Intoxication has set in and the Ketel One keeps flowing.

The Dow stands at 13,507 --a dizzy distance from 7,702 where it bottomed out in 2002. Profits are good, the economy is strong, and none of this has anything to do with the market's future direction. That's because the market discounts events long before they occur. The rally over the past several years already priced in the prosperity of the present. Today's complacent market must now look to the future. And the future will include another terror attack on American soil or some other cataclysm. That's not an 'if' but an unfortunate 'when.'

If my students remember nothing from any given semester (always a possibility), they at least come to understand the psychological nature of markets. This shrink-like approach is called "behavioral finance." It explains why securities get overpriced as traders grow too optimistic and why they become cheap with despair. It also explains how the market prices in certain expectations, the good, the bad --and the ugly.

In the wake of 9/11, the market started to price in a terror "premium," meaning that stocks started to reflect a scared new world of dangerous geopolitics. Stock prices tanked. The multiple that people were willing to pay for stocks shriveled. If they had been willing to pay $25 for each dollar of a company's earnings, now they were willing to pay only $18. A terror premium had embedded itself into stocks, so prices had to come down. The notion of a premium making prices lower may seem counterintuitive. The premium increases as people are forced to take on more risk to seek reward. And to allow opportunity of future reward at increasing risk levels, prices have to go lower today.

The market has stopped pricing in a terror premium because investors have two wonderful ways to cope: deny and forget. Denial: ignore future risks because they "can't happen to me." Forget: dismiss past market events from the collective radar screen. It might serve an evolutionary purpose to forget the pain of being mauled on that hunt for wild boar. But in the world of investing, amnesia can be fatal. No event repeats itself in a precise encore; however, market history has haunting choruses that strike similar chords. As Mark Twain said, "history doesn't repeat, but it rhymes."

There's a lightheadedness to today's private equity binge that recalls those carefree days of 1999--a year when Ms. Lohan still had to have a fake ID. The public has forgotten that time (and the resulting crash) as surely as if they'd blacked out on an all-night bender. Today, I have very few clients asking if their portfolio is well-positioned for a terror attack. Only a couple of years ago, I had many. This points to a dangerous lack of fear.

I am pruning stock positions in separate accounts, but I'm overweighting large-caps (which, due to lower valuations, are best poised to withstand a downturn) and healthcare which is also cheap and more immune to these particular forgotten risks. Finally, I'm trimming the small-cap and emerging market allocations to the bone. I don't like to try to time the market, especially based on reflexive contrarianism, as opposed to irrefutable overvaluation. As any money manager knows, the chances of getting it wrong are high. I liken such market timing to surgery --always a last resort-- but when necessary, absolutely necessary. Sometimes the patient just looks too vulnerable for a holistic approach.

The long-term story for the market is still one of glory: globalization, economic expansion and developing markets will all ensure a productive future. But first the binge will turn to purge. Like all celebrities who get too carried away, the stock market must eventually be tossed back into rehab. That will be the time to buy.