Over the past year, some of our clients questioned why we continued to adhere to a conservative investment approach when stocks were advancing.

In spite of strong market gains in 2009, we believed that market risk remained high and that the economic recovery might be too fragile to endure. Events so far this month seem to support that reasoning.

The one-day market slide on May 6 is being called the “Flash Crash.” A May 18 article by Wall Street Journal reporter Scott Patterson noted that the May 6 slide had similarities to the Black Monday crash of 1987.

“Technological innovation has been widely touted as having made the market more efficient—and more resilient. Instead, the May 6 drop—while much smaller than the 1987 crash—showed that technology mainly served to speed up trading and magnify the market moves.”

The article noted that the worst portion of the May 6 descent lasted about 10 minutes. The decline was 9.8% at its worst point and trades reached 19 billion shares.

Although stocks quickly recovered much of the May 6 loss, it still should serve as a warning to show how quickly the situation can unravel.

Before that one-day demonstration of volatility, there were signs that the U.S. still faces daunting economic challenges. And while stocks can rise during a weak economy, there is usually a time of reconciliation.

In a May 17 Fortune article Shawn Tully also referenced the 1987 crash:

“Don’t be deceived by the rebounding economy … Right now, stocks are extremely vulnerable to the same scenario. The reason: The market is even more overpriced than when thunder struck on that distant Black Monday.”

Tully’s article explained that the 60-year price-to-earnings ratio (P/E ratio) of the S&P 500 is slightly less than 14. After the market correction that began in late 2007, the P/E ratio fell to 13.3 in March 2009. That was the same level reached after the 1987 Black Monday crash. By May 2010, the P/E ratio climbed back to 22.  (See below for a more detailed explanation of P/E ratios).

“So what do the current … PEs tell us about the future of stock prices? The best bet is that equity values, like most investments, revert to the mean.”

Then Tully notes what returning to the mean would entail:

“How far must prices fall to get back to basics? For the S&P to return to a PE of around 14, the index would need to drop by around 33% to less than 800, its range in early 2009. That would substantially raise dividend yields, and raise future real returns into the high single digits, where they belong.”

It is important to understand that no one knows exactly when that move to the mean will occur. It could be next month. It might not be for 10 years.

As measured by most technical indicators, major stock indices have turned negative. The Dow, the S&P 500, the Nasdaq and the NYSE composite are all below their 200-day moving averages. Other indicators like the moving average convergence divergence (MACD), relative strength index (RSI), and stochastic oscillators are negative and reflecting high levels of selling pressure.

Unfortunately, even the best tools in the world cannot tell us what the financial markets will do over the next few sessions. All the information means at this point is that from a macro-economic view, the economy remains relatively weak and market risk is elevated. Even so, strong upward market moves can occur, as we witnessed for much of 2009.

But based on what is currently happening in the economy and the markets this is a time for caution and not speculation.
F.S.