“If we are to assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue – relatively at least – companies that are out of favor because of unsatisfactory developments of a temporary nature.”

Excerpted from “The Intelligent Investor” by Benjamin Graham

April marked the sharpest sell off in stocks since the preceding July, at the very outset of the Federal Reserve’s recent campaign to raise short-term interest rates and beat back the inflation bogeyman. For investors, May brought new hope that the market could shrug off the negativity of the prior month and push higher. They should not have been disappointed.

The U.S. equity markets rallied strongly, posting their most significant single month gains since those during the post-election rally late in 2004. The S & P 500 Index rose 3.2%, reversing two months of losses and raising its year-to-date return to within a fraction of breakeven. Smaller cap issues fared even better, with the Russell MidCap and 2000 indices gaining 4.8% and 6.6%, respectively. The rebound extended not only across market capitalization, but also encompassed both value and growth issues. Despite the strength of the domestic returns, the equity markets abroad provided only tepid support to portfolio returns. The Morgan Stanley EAFE index was essentially flat, gaining less than 0.1%.

Bonds also found their footing during the month, discounting the most recent announcement of another 25 basis point increase in short-term rates by the Federal Reserve. The benchmark ten-year Treasury yield declined by 19 basis points to close the month at 4.01%. The Lehman Aggregate Bond Index returned 1.1% for the month, outpacing the Lehman Muni Bond Index 5 year’s return of 0.3%. International bonds also rallied with a monthly return of slightly below 1.0%.

While equity valuations continue to trend slowly downward, there appear to be limited tactical opportunities available to the investor. Increasingly, there is quantitative evidence suggesting that the value-driven cycle that the market has been in since 2000 is getting long in the tooth. Growth stock valuations are becoming increasingly appealing; the P/E ratio of the Barra Growth Index of large company growth stocks has reached its lowest point since 1996, well before valuations skyrocketed in the midst of the technology bubble. Small cap growth stocks also continue to look comparatively more appealing relative to small cap value stocks based on numerous quantitative valuation measures. Despite these positive indications, the timing of an inflection point that may tip the markets toward growth is uncertain.

That being said, we believe that large cap equity portfolios with a current value bias should be repositioned more neutrally between value and growth. It is certainly possible that some combination of individual company strength, macroeconomic fundamentals, or irrational investor decision-making could perpetuate the flow of capital into traditional value stocks beyond a reasonable point. Whether or not the lessons of the technology bubble and its subsequent decline has been pushed into the recesses of the collective mindset of investors cannot be determined.

Another period of “irrational exuberance” could create another extreme imbalance, albeit unlikely, within the stock market, this time favoring value stocks.

For some, the idea of investing in growth stocks may still be distasteful, a qualitative factor that could eventually drive the relative value of growth shares to even more attractive levels than those today. Nonetheless, even some traditional value managers have noted that many so-called growth stocks look increasingly cheap. At some point, “growth” will be growth in name only, with the underlying fundamentals suggesting that there could be great potential value in those companies. Value investing is sometimes misunderstood to mean the avoidance of growth stocks. In reality, value investing is finding those segments of untapped value in the market, even if it means avoiding highly priced value stocks in favor of cheaper growth issues. Benjamin Graham, one of the greatest investment minds and the father of value investing, understood this. It is still a lesson that many investors (and probably a fair number of investment managers) have failed to fully grasp.

We do not believe we are at another point of “irrational exuberance” today, but in a rational market, that point may not be reached. A neutral position driven by valuation fundamentals, even if premature relative to the direction of the broad market, appears to be the most prudent, and truly value-oriented, approach to investing in the current market.