The price-to-peak earnings multiple held steady at about 11.3x last week. Stocks sold off at the end of last week, as disappointing consumer confidence data coupled with unimpressive retail sales prompted investors to take profits. We continue to believe that the overall market’s valuation is not appealing after the strong and sustained rally in equities over the last five months.
The strength of the rally has come largely from a stabilization in macro economic data, and the past two earnings seasons. With more than 90% of the S&P 500 having already reported second quarter results, an astonishing 75% of companies have beaten Wall Street analysts’ expectations. However, of the companies that have beaten bottom line estimates, more often than not it is because of cost cutting rather than improved revenue figures. Nowhere is this more apparent than the retail industry, which is dealing with sluggish consumer spending. The most notable earnings releases yet to come are out of the retail industry, but we would not expect anything terribly impressive. We are seeing consumers retrench as the cost of borrowing is higher now than over the past ten years or so. Historically speaking, over the last 60 years consumer spending has accounted for roughly 65% of the economy, but more recently with easy available credit economists have expected 70% or more. We believe that this sector of the economy is starting to edge down to the lower historical levels bit by bit.
Long term returns are built on fundamentals such as earnings and sales, but the recent rally has largely benefited from the conventional wisdom that the worst is behind us. While this may be the case, we believe that there is not sufficient evidence to issue the “all clear”. So, after equity’s impressive run, we believe caution will be justified heading into the fall months. Remember that September is the only calendar month to have a net negative return dating back to 1926! (link)
The percentage of NYSE stocks selling above their 30-week moving average was down very slightly, but still elevated at 89%. While this sentiment indicator remains at extremely lofty heights, we are perceiving a very different trend among analysts and commentators over the last week or so. Even the most bullish of analysts now requires more evidence that the run up in stocks can be justified. Many of the issues that sent the financial system reeling are still in place; such as rising unemployment and foreclosures, many bad loans on bank balance sheets, and a cash strapped consumer. The government has provided a backstop to many of the financial sector’s issues, but just last Friday we saw the largest bank failure of 2009 with Colonial BancGroup.
This extremely high sentiment level may be due for a reversal, unless this rally can defy our expectations for a correction. The rally has been impressively diverse as indicated by the breadth of the rally (advancing versus declining issues), but the volume sponsorship has been weak for quite a number of months. We are experiencing a market that is overbought and trading at unattractive valuations, so it will be quite a feat to continue to climb in the face of such headwinds.
Our research continues to advocate a defense stance for present conditions. The market is overbought in the short term based on investor’s excitement over the better than expected earnings, and projections for continued improvement. When taking a step back, we think that the “Great Recession” may have the last laugh. Better than expected earnings does not necessarily equate to a healthy economy, instead it could just point to overly pessimistic analyst estimates. Furthermore, there are too many important and nagging economic issues that show few signs of easing in the coming months.
We understand that the market most often leads the economy on the way out of a recession, but after this nearly 50% advance from the trough this is not the optimal market to put more resources into the market. The expected return on the market over the next few years (incorporating major improvements in earnings going forward) does not offer the kind of return required for the risks of this market environment.
