The price-to-peak earnings multiple held steady at 11.5x last week. The stock market was just about even for the week, although most of the economic data showed improvement and earnings reports were stronger than expected, particularly those from the Technology sector. Durable goods orders, 2Q GDP, consumer confidence, and housing data were all stronger than experts thought. The fact that stocks did not gain very much after improving data points could be a signal that the rally is taking a much needed breather. With second quarter earnings season ended, there are few reports of consequence until October which will make new economic data points carry an even greater weight in a market needing confirmed economic improvement. Looking ahead, the August jobs report will be closely watched, as unemployment remains a key reason that some are skeptical of the rebound in the economy.
The huge rally in stocks since March has made the market appear much less attractive from a long term investors standpoint. There has been a substantial amount of economic improvement “baked-in” to the market at these levels, and that is why even better than expected data attracts little enthusiasm from the market. We believe that on the eve of September, the market’s worst month historically, there is a very good chance that a pull back will be necessary.
The percentage of NYSE stocks selling above their 30-week moving average inched up to 91% this week. Long time readers will know that we are always skeptical of an extremely bullish or bearish sentiment when such a condition prevails. As we mentioned earlier, there has been so much economic improvement already priced into equities, which makes this market at greater risk when disappointment strikes.
If nothing else, when the market is as bullish as it currently is, then it becomes that much harder to find a stock attractively priced. If after reading our cautious view of the market, you still find yourself with an uncomfortable amount of cash on hand and needing to increase equity exposure, we would recommend buying the high-quality stocks. That means stocks with strong balance sheets unencumbered by debt, and market share leaders are generally less
economically sensitive.
The latest rally has been characterized by lower quality stocks getting the best returns, see recent returns for AIG (AIG), Citi (C), Fannie (FNM), Freddie (FRE) and others. Apart from Citi, it is debatable that the common stock in the others has any value at all. For example, recent data shows stocks with declining sales have somehow beaten the returns of those companies still growing revenue. Furthermore, companies that have a lower ROE than the median-level have outperformed the stocks that have better than average ROEs. We may not know which direction the market is headed, but judging by long term returns over full market cycles, you can believe that fundamental strength will be recognized eventually.
As you have probably realized, the Ockham asset allocation model advises less than your normal allocation to equities. Stocks are not cheap, unless you believe that there will be a rapid return to 2007 record corporate profits. We happen to think that a quick return to those levels is not likely, particularly in an economy still in the process of deleveraging. There are simply too many risks in this market that continues to climb. There is a good chance that the lack of better than expected earnings reports (largely enabled by deep cost cutting) over the next few weeks could enable a market correction to a more attractive level.
