The price-to-peak earnings multiple advanced to 13.1x after the fourth-straight weekly gain in US stocks. Healthcare reform (HCR) was passed and signed by the President last week, but there are many challenges ahead; most notably, a number of states have filed lawsuits against the federal bill. We found it surprising that equities rallied on the healthcare bill’s passage, since it transfers more power to the government at the expense of the private sector and has already resulted in massive charge-offs at major corporations. Caterpillar (CAT), Deere & Co. (DE), 3M (MMM) and AT&T (T) are among the companies who have announced major accounting hits in expensing the changes wrought by the reform bill. With AT&T reporting it will take a $1 billion charge in the first-quarter thanks to the loss of tax-free status for covering retiree healthcare costs , it appears that the law of unintended consequences is already at work. Benefits consultant Towers-Watson estimates that US corporate profits will decrease by as much as $14 billion as a result of healthcare reform. Ouch!
So, why did the market rally on such news? For one thing, the year-long HCR debate created an overhang of uncertainty on the market and any resolution was a welcome change. However, at Ockham, we believe that over the long-term the market’s movement is driven by fundamentals such as profits, so any extraneous input that threatens corporate profitability should be met with displeasure from the stock market. We continue to believe that earnings estimates for the current year assume an extremely robust recovery in corporate earnings and that HCR will make current earnings forecasts even more difficult to meet.
The percentage of NYSE stocks selling above their 30-week moving average slipped to 75% as of last week’s close. Sentiment remains extremely elevated, although it has begun to normalize over the last few weeks. The market’s current trend continues to point
higher, and we believe this is largely due to sentiment rather than fundamentals. Some stocks such as Best Buy (BBY) and Williams-Sonoma (WSM)–both with relatively heavy exposure to consumer sentiment–have produced results that point to a recovery in consumer spending. However, bad news in other economic sectors is simply brushed off: rising Treasury interest rates, poor home sales and increasing mortgage delinquencies, not to mention continued problems in the European Union.
With sentiment being a key driver of the market’s momentum, investors must ask themselves how much longer the run will last. The market has rallied for more than a year now and is in an overbought condition; thus, we would that conservative investors raise cash. The economic recovery is underway, but we believe its still extremely vulnerable to any number of potential dangers.
We consider the current market overbought and overvalued, and we must urge investors not to be lulled into a complacent mind set. Just because the bulls have been in control for more than a year does not mean that all is well and we see many reasons for concern in the months ahead. Dr. John Hussman issued a warning in his Weekly Market Comment for what could be a “perfect storm” looming on an investor’s horizons.
“As I emphasized last week, even if we had no concern at all about a second wave of credit strains, we would still be fully hedged here based on the present combination of rich valuations, overbought conditions, overbullish sentiment, and hostile yield pressures. Presently, we are also at the peak of concern about the potential for fresh credit difficulties to emerge, as we move into the first portion of the Alt-A / Option ARM reset schedule.
We will respond to the data as it emerges. This allows several possibilities. In my view, the most likely outcome is that we will indeed observe serious credit strains in the months ahead. That possibility adds to an already unfavorable syndrome of overextended market conditions, and this mix of factors courts a great deal of potential risk. The CBOE volatility index – a measure of expected market volatility – dropped below 17 last week, while mutual fund cash levels have dropped to a historic low (and are depressed even after adjusting for the low level of interest rates). Given the extreme complacency of investors here, we may have the elements of a perfect storm.” — Hussman’s Weekly Market Comment 3/29/2010
