The price-to-peak earnings multiple rose slightly to 12.7x as of Friday’s close. Stocks finished the week up slightly, but excluding gains on Monday which were driven by last weekend’s ECB sovereign debt bailout package, equities would have dipped for a third straight week. First quarter earnings season is nearly finished and once again US corporations have had little trouble topping analyst’s profit estimates. While strong revenue growth remains elusive, we continue to believe that fundamentals have improved greatly. However, we currently see markets being driven less by fundamentals and more by macroeconomic themes such as the European debt mess and the increasing perception of an anti-business bias in Washington.
The recent pull-back in stocks has reduced their over-heated valuations and made them more attractive on a relative basis. Still, we recommend a cautious stance when deploying new capital at this time as markets remain jittery. As we have pointed out before, during the current bull market we have not seen even a 10% pull-back in equities. We think that such a retreat may be underway (a 10% decline from the top would bring the S&P 500 to just below 1100), which would be be positive for stocks, since it would reduce current over-bought conditions.
The percentage of NYSE stocks trading above their 30-week moving average advanced to nearly 62% as of the close of trading last week. Despite rebounding from under 50% last week, this metric of investor sentiment is still at levels which we would consider fairly normal especially in a rising market. In recent week’s the VIX–regarded as the best gauge of volatility and fear in the marketplace–has spiked to its highest level in more than six months. This has reduced somewhat our worries about investor complacency. At present, we think that downside risk outweighs potential gains to the upside and investors should reduced portfolio risk levels accordingly. Owning stable, dividend-paying stocks is one way to reduce risk, as is allocating a small portion of your portfolio to safe-haven assets such as precious metals.
As long time readers are aware, we have believed that the market has been overheated for some time now, but also warned against “fighting the tape”. Now that “the tape” is moving against the bulls, we believe it appropriate for long term investors is to reduce risk and take profits in winners. Indeed, we remain very concerned over the developing situation in Europe, as essentially markets are having to place faith in politicians’ ability to carry out austerity measures over the course of many years. At the very least, a sinking EUR/USD exchange makes American exports less competitive around the world versus their European competition. In a worst case scenario, we could see further instability in Europe lead to a global contagion similar to what we experienced after the fall of Lehman Brothers in the autumn of 2008. Opinions vary widely on the European bailout and what it will mean, but we think the market’s reaction is perhaps paramount as a tool for evaluating its perceived effect. For a succinct view of the situation we turn to one of our favorite economists, Dr. John Hussman:
“Presumably, the ECB hoped that the 750 billion euro figure would inspire shock and awe, but after a quick rally on Monday, the markets were neither shocked, nor durably awed, as investors began figuring out that the ECB was essentially promising to buy Euro-debt with Euro-debt, and to defend euros with euros.
In the end, as I’ve argued repeatedly over the years, monetary policy is only as good as fiscal policy. A central bank does not have wealth of its own. It is a zero-sum entity that can only enrich those from whom it purchases debt by debasing the relative wealth of people who hold the existing stock of currency. If a government insists on running deficits, engaging in wasteful spending, and dissipating public resources to bail out private bondholders, it has to find somebody willing to buy its debt. If it does not, the central bank buys it, and dilutes the currency by doing so. The situation is particularly insidious when the central bank buys low-quality debt, because there is no taxing authority behind it to provide a basis for confidence in the currency.
The Euro-area has a special problem in this regard, because the bailouts represent clear country-to-country transfers of wealth, and risk creating inflation for all the members of the European Community in order to defend the deficit spending of countries that simply do not have enough flexibility to cut those deficits. Greece in particular is likely to experience so much loss of output that it will most likely lose on the revenue side much of what it cuts on the spending side. For that reason, the deficits are likely to come down much slower than expected. Germany, with its particularly strong aversion to inflation, is unlikely to accept the costs for long.” – Hussman Funds, Weekly Market Comment 5/17/2010
