The price-to-peak earnings multiple comes in at 12.2x as of Friday’s close after the S&P dropped slightly last week. Earnings are still well below peak levels, so this valuation measure is moving in concert with the S&P 500’s vacillations. From our perspective, stocks remain vulnerable after rallying sixty percent off their early March lows, especially given the fundamental weakness still evident in the overall economy. Recovering corporate earnings have helped fuel the stock rally, but virtually all of the good news has come from cost reductions. Very few companies are experiencing sales growth, even off last year’s depressed levels. More recently, stocks have rallied not so much because of good earnings news, but rather thanks to continued weakness in the dollar. If you measure the market in terms of euros (which have been far more steady than the dollar over the past few months) stock gains have been much more subdued. It is likely that the market will continue to rally on the dollar’s weakness and fundamentals seem to point to further dollar weakening going forward. At this point, while the market may chug higher over the next few weeks, the rally is no longer based either on attractive valuations or strong economic fundamentals.
The percentage of NYSE stocks selling above their 30-week moving average declined slightly over the last week to 80%. Our sentiment indicator remains firmly in bullish territory, although it is down from multi-decade highs. We would expect further normalization in the coming weeks. Last week, we saw investors generally reduce their risk exposure as defensive stocks performed better than more risky ones. Pharmaceuticals and telecom were the best performing stock sectors, while technology and consumer discretionary were the weakest. Gold, which is a hedge against both inflation and economic uncertainty, had another great week, up 2.7% and continues to set new highs.
While we continue to believe that investors should be long this market, we also believe it prudent to have greater than normal cash exposure, given the strong run that stocks have seen. The market may well move higher based on continued dollar weakness but we view this as a poor catalyst for a sustainable bull market.
The latest housing data from the Mortgage Bankers Association which suggests continued weakness in this crucial area of the economy will undoubtedly put further pressure on the already-battered balance sheets of financial institutions around the country. MBA’s Chief Economist Jay Brinkmann noted that the mortgage delinquency rate (loans at least one payment behind) hit 14.41% this month, which is the highest ever recorded in their survey. In addition, the report stated:
“Job losses continue to increase and drive up delinquencies and foreclosures because mortgages are paid with paychecks, not percentage point increases in GDP. Over the last year, we have seen the ranks of the unemployed increase by about 5.5 million people, increasing the number of seriously delinquent loans by almost 2 million loans and increasing the rate of new foreclosures (on a quarterly basis) from 1.07 percent to 1.42 percent…
The outlook is that delinquency rates and foreclosure rates will continue to worsen before they improve. The seriously delinquent rate, the non-seasonally adjusted percentage of loans that are 90 days or more delinquent, or in the process of foreclosure, was up from both last quarter and from last year. Compared with last quarter, the rate increased 82 basis points for prime loans (from 5.44 percent to 6.26 percent), and 216 basis points for subprime loans (from 26.52 percent to 28.68 percent).”
When these soured loans begin to show up on financial firm’s balance sheets, it could renew fears of a “credit crisis” especially since the data appears to be worsening. Such a development could trigger a sharp correction in stocks. We advise caution going into the end of 2009 and early 2010.
