The price-to-peak earnings multiple moved to 11.3x this week. Boosted by better-than-expected job loss data, the stock market finished the week on a strong note. The S&P 500 has now cleared the 1000 point hurdle and we believe that this advance prices in a fairly robust economic recovery. Thus, we reiterate our position that the stock market is heavily overbought from a short term perspective. For example, if you look at the 50-day moving averages for the ten major sectors of the S&P, all except for Energy appear substantially overbought.
Predicting the future is extremely difficult in any market environment and is even more so at this unprecedentedly volatile time. The economy is still recovering from the global credit meltdown, the ramifications of which we are still feeling. Credit markets are improved over where they were just a few months ago, but defaults and delinquencies remain persistently high and will for some time to come. Lending activity is contracting, as seen in the Fed’s report on consumer credit shrinking at a very rapid rate. This global de-leveraging is not surprising and is necessary. At the height of the bubble when the S&P 500 was trading at over 1500, corporate profits margins were out of line with historical norms and worse, an abnormal portion of those profits were coming from the highly-levered financial sector. Making forward-looking comparisons to this extremely unique period is difficult.
One thing we know, historic recoveries from burst bubbles rarely come in the form of a V-shape. (We heard the term “a square root sign-shaped recovery” being used on CNBC this morning.) Generally, stock charts of these events feature a steep drop and then flat-line for quite some time. Thus, we are not eager to place more assets at risk in such an overbought market.
The percentage of NYSE stocks selling above their 30-week moving average continued climbing to over 89%. It has been both impressive and surprising that stocks have rallied with very little in the way of pull-back. We view this as a signal that the market over-corrected on the downside when the financial sector was on the verge of a complete collapse. Sentiment cratered to levels unseen in over two decades. Analysts and economists became extremely pessimistic about the future of the global economy. As contrarian investors, we always are very skeptical when any tenet or concept
among investors becomes too widely held.
Now, with a consensus view emerging that we have seen the worst of the Great Recession, we see signs that optimism among stock investors may be too widely held. This is worrisome for a number of reasons. For example, the market was up strongly on Friday because the employment data for July was better than anticipated. Yet the U.S. economy shed another quarter million jobs during the month and, frankly, the unemployment rate improved because nearly twice that number of people dropped out of the pool of those seeking employment. The rate of decline of job losses is important, but looking at the whole picture reveals little cause for celebration.
Our asset allocation model advocates–for the third week in a row–underweight exposure to risky assets. To be clear, we are not advising a complete withdrawal from stocks; instead we think it appropriate to lessen the amount of risk in one’s portfolio. Simply put, the market is too hot for us to get excited about buying into such strength but this does not mean that it cannot continue to rise over the next few weeks. We think it is likely that we will see a correction to clear this overbought condition but we make no attempt to time that downturn. Rather, it is better to continue to adjust portfolio allocation with an eye toward the appropriate risk/reward tradeoff.
