The price-to-peak earnings multiple declined to 11.5x as of last week’s close. U.S. equities have sold off for two consecutive weeks now, as investors search for confirmation that the six month rally is justified by actual fundamental economic improvement. This is what Dr. John Hussman refers to as the “show me” phase. In the last week, with earnings season just days away, the market was sent reeling by weak unemployment data, consumer confidence woes, and a sluggish PMI reading.
As we noted last week, the market’s current swoon matches its behavior during the same period leading into earnings season last quarter. Third quarter earnings season officially kicks off with the first DJIA company to report, Alcoa (AA), on Wednesday afternoon. This time around, we expect that stock investors need solid confirmation that an economic recovery is really underway. Cost cutting has enabled companies to beat analysts estimates for the past two quarters despite generally weak revenues. However, costs can only be cut so far and Wall Street needs to see improving revenue trends soon. Furthermore, analysts have been ramping up estimates in order to make up for their overly bearish earnings projections earlier in the year. Thus, we are not anticipating such a great majority of companies to outpace estimates as we have seen in the last two quarters.
That being said, with earnings coming in nowhere near their peak 2007 levels, the market is not very attractive from a valuation perspective. While there is no way to foretell the direction of the market in the near term, it seems to us that its risk/return profile is not enticing at present.
The percentage of NYSE stocks selling above their 30-week moving average remains elevated at 91%. We are getting a very curious dynamic among various measures of sentiment. Some are continuing to grow more bullish. The Investors Intelligence survey of stock newsletter editors shows a ratio of 2:1 bulls to bears. The AAII survey of individual/retail investors is also becoming more bullish standing at 44% bulls to 35% bears compared to last week’s reading of 39% bulls and 45% bears. Of course, Ockham’s sentiment metric remains off the charts to the bullish side.
However, at the same time, equity fund flows–often considered a gauge for individual investor sentiment–show a $29 billion outflow of cash from stock funds in September. Meanwhile, bond funds had an inflow of $46 billion during the same time period. This seems to contradict the surveyed bullishness of individual investors. In addition, a different index of sentiment from investment newsletter editors betrays an increasingly bearish tone. Bullishness as measured in the Hulbert Stock Newsletter Sentiment Index has declined from 45.2% to 29.1% in a period of less than two weeks.
In each case, these sentiment indicators are showing contradictory results while polling the same community of investors. We will continue to monitor the overall trends in sentiment, but we believe that that bulls remain in control as affirmed by our sentiment indicator.
The market is again at a crossroads with an extremely important earnings season on deck. The market has already priced in substantial economic improvement and a quick return to pre-recession earnings levels. If the recovery is in fact slower and weaker than this, we would not be surprised to see stocks pull back, perhaps significantly.
It will come as no surprise that our asset allocation model remains defensively positioned right now. The 50%+ rally from the March lows has been impressive, and the S&P 500 just completed a second straight quarter of double digit gains. Such a performance in consecutive quarters has not happened since 1985. Long-term investors would be wise to reduce risk in their portfolios following such impressive market gains.
