The price to peak earnings multiple dropped to 12.2x as of last week’s close. This measure of market valuation fell from near its 16-month high last week following the stock market’s worst three-day sell-off in almost a year. The dollar was the lone bright spot as equities and commodities were big decliners for the week: DJIA -4.1%, S&P 500 -3.9%, Nasdaq -3.6%, Gold -2.4%, and Crude -4.7%. A strengthening dollar could actually trigger a market sell-off as we explain in more detail in our blog: Is the Carry Trade Unwinding?
One other possible reason for the late week sell-off was data out of China showing that GDP grew at an exceptionally fast 10.7% rate in the fourth quarter, which added to nascent inflation concerns in the financial markets as some observers now see a rise in global interest rates as almost unavoidable. China’s economic growth has played a major role in fueling the so far under-whelming global recovery and were Beijing to apply brakes to its economy, this would have a deep impact throughout the world.
The market’s sell-off was a reminder that stocks never go in one direction indefinitely. In general, we are neutral regarding the overall market’s valuation right now, but believe that the ten month bull market remains very susceptible to downside risk. The market rallied well in advance of fundamental improvement and–in many cases–stocks now must justify their recent gains. The S&P 500 is up 31% over the last 12 months; now investors need to see solid evidence of both revenue and earnings growth to justify such a surge. We think investors are right to lock in some profits in a still-very-uncertain environment.
The percentage of NYSE stocks trading above their 30-week moving average slipped to 74% amid a marked shift in investor sentiment. Sentiment turned more bearish last week for a number of reasons and signaled a return to more normal, moderate levels. In addition to China’s “too hot” growth, other reasons for concern include: sub-par revenue growth in many quarterly earnings reports, initial jobless claims remain worse than expected (40,000 worse last week) and, perhaps most importantly, the administration’s newly-announced domestic policy initiatives are viewed as anti-Wall Street. In particular, the President’s proposal to limit many of
the trading operations often responsible for generating a large chunk of the profits at financial institutions such as Citigroup (C) and Goldman Sachs (GS). The proposal would be similar to the the former Glass-Steagall Act–enacted in 1933 following the Great Depression–which effectively separated the traditional commercial banking system from the highly-leveraged and speculative activities of trading desks.
This proposed legislation is championed by White House economic adviser Paul Volker and will certainly warrant political debate as to what are appropriate and wise regulatory actions in such a challenging economic environment. If enacted into law, the legislation may in fact reduce systemic financial risk, but the timing of the announcement, coming on the heels of the election of Republican Senator Brown in Massachusetts and amidst so many other weighty factors triggered a round of significant bearish activity late in the week.
We continue to believe that long term investors are better served by remaining cautious in this market climate. Volatility made a strong comeback with the VIX indicator spiking late in the week and options traders bid up call options on the VIX to a 19-month high. Clearly, traders are not convinced that last week will be the end of this volatile trading. Again, we do not make predictions about the near-term direction of the market, but we think that the risk outweighs the potential rewards at present. Value investors should consider rebalancing their portfolio towards defensively-natured, income-producing stocks.
