The S&P 500’s price-to-peak earnings multiple entered the new decade at 12.5x as of the close of trading on December 31, 2009. At first glance, 12.5x seems a relatively benign peak earnings multiple as we normally consider any number under 15x to be moderately attractive. However, current earnings are a far cry from the peak levels we saw in the summer of 2007. At that point, S&P 500 earnings were about $89 per share thanks in part to the contributions of highly-leveraged financial firms. Although earnings are clearly beginning to improve, reported earnings over the past 12 months are still about one-eighth of their peak. We expect that corporate earnings will continue to normalize over the course of 2010, but much of this growth has already been priced into stocks.
This morning on CNBC’s Squawk Box a commentator made a bullish case for the market going forward which was predicated on a belief that corporate earnings will continue to improve. Furthermore, he stated that he believes that in addition to the improving earnings outlook, the market will see price-earnings multiple expansion in the year ahead. Were his forecasts to prove correct, 2010 would be a great year for equity investors. At Ockham, while we agree that corporate earnings are on the upswing, we are unconvinced that P/E multiples will inflate much, especially given the risk of rising short-term interest rates should economic acceleration continue. We think that the earnings improvement that we are beginning to see and expect to continue has largely been baked into current market levels.
The percentage of NYSE stocks selling above their 30-week moving average fell to 82% following the late day sell-off on Thursday. The sell-off was likely the result of profit taking in a very low volume environment more than any other factor. The S&P 500 surged by 25.9% for the year including dividends, and investor sentiment appears bullish headed into 2010 as well. The majority of Wall Street prognosticators are bullish for the year ahead as are retail investors according to AAII with 49.2% bullish compared to 23% bearish. We continue to be skeptical of any opinion where you see this much of a consensus; in this case the bulls heavily outnumber the bears.
As we leave the 00’s behind, we think it is worth taking a look back for lessons to be learned. The decade will not be remembered warmly by investors as the S&P 500 lost 23%, and the tech-heavy NASDAQ slipped 43% since the start of the millennium. The decade saw two major recessions with the dot-com bubble bursting at the outset and the credit collapse bracketing the back end. (The decade also saw the 9/11 attacks, which were directed largely at the financial markets and did suspend trading for a number of days.) We advised caution as the price-to-peak earnings multiple soared to extreme highs (above 30x) while the dot-com bubble inflated. One of the critical lessons to take away from the past ten years is that traditional measures of market valuation do actually matter and the phrase “it’s different this time” is still a sure sign of looming trouble. Thankfully, today’s market P/E multiple is not nearly as unattractive as it was ten years ago.
For long term value investors, we are advising exposure to the equity markets albeit with a reduced risk profile. With sentiment firmly in bullish territory and valuation not particularly attractive, this isn’t the sort of market that Ben Graham would buy into. That being said, there are undervalued stocks in any market if you know where to find them.
