The price-to-peak earnings multiple has increased to 12.2x as of the close of last week’s trading. The S&P 500 index advanced about 1.5% in the last week, as earnings reports were largely better than expected from a profit perspective. As we had anticipated, revenue growth has surpassed earnings in terms of importance to the markets for many companies. One reason for this shift is that sales numbers cannot be massaged by accounting principles, and it can be argued that sales growth is a better measure of corporate health. Examples of this sort of reaction from the market could be seen across sectors in reports from Pepsi (PEP), Johnson & Johnson (JNJ), and General Electric (GE) among others.
While a price-to-peak earnings multiple at 12.2x on the face of it is not particularly distressing, one has to consider the fact that earnings are currently nowhere near that peak level of more than two years ago. Of course, the majority of earnings write-downs occurred about this time last year and extended through the end of the year, so we expect the reported earnings number to start to adjust higher towards the end of the year. That being said, according to our data trailing twelve month earnings (reported) on the S&P 500 are currently 78% lower than a year ago, yet the index is trading 15% higher. We think it is clear that the current market valuation is unappealing for long term investors at current levels.
The percentage of NYSE stocks selling above their 30-week moving average has increased to 90%. Technically speaking, sentiment remains at an extremely elevated level by our market wide sentiment metric. We are experiencing a market that is what we consider strenuously overbought for about 2 months now, and it is an additional reason for concern as a correction to more historically normal sentiment levels would most likely require lower prices.
As we wrote last week (An Enlightening Day for Goldman Sachs), the market’s reaction to Goldman’s (GS) quarterly performance was an important event that we believe shows the “irrational exuberance” that exists in this market. Goldman reported an impressive quarter with earnings beating estimates by about 25%.
However, the stock failed to match the prevailing “whispers” hoping for an even more impressive quarter. The result was that the market sold off after Goldman’s impressive quarter. At Ockham, we believe this is a microcosm of what we expect to see from the market going forward. The expectations have been set so high by the market’s robust rally since March, and any developments that do not live up to those lofty expectations will be met with resistance from the market.
When stocks began to recover in March, it was clear to us that the market was priced for a continuation of the economic difficulty of the credit crunch for some time. The next two quarters saw the market rally because the reality was not quite as bad as feared, and there was indeed a light at the end of the tunnel. Now, we expect the market will require some proof that the rally of more than 60% from the nadir will be justified by improvement in corporate earnings, a rebound in sales, and economic improvement.
Viewing the market from the lens of a value investor, we are uninspired by what we are seeing. We believe the rally has been largely thanks to quantitative easing and the dollar’s swoon, and these are hardly the sort of organic improvement that gives confidence. Our concern is that the real economy–seen primarily in foreclosures and joblessness–is headed in the wrong direction and shows few signs of reversing course. How long can the disconnect between Wall Street and the real economy continue? We continue to advise a defense stance for long term value investors.
