The equity markets rose about one percent last week, which brings the price-to-peak earnings multiple to 11.1x. The rally’s reemergence during July was indeed impressive after faltering in late June on questions over the strength and sustainability of the recovery. In fact, the Dow 30 enjoyed its best month since October 2002. The strength of the rally has thus far been the result of earnings that have exceeded Wall Street projections the majority of the time. As we have continually noted, earnings are strong compared to estimates (primarily due to cost cutting), but when compared against the earnings results a year ago there is still reason for concern.
At this point, the market has regained about a third of its losses since the S&P reached its high in October of 2007. When the market reached the March lows it had lost about 57% from peak-to-trough; since that point, stocks have recovered only a little more than a third of prior losses. So, even though the rally has been sustained over the past 4.5 months, the size of the gains and the lack of sponsorship on a price-volume basis is consistent with a bear market rally. As often happens the market can overshoot to the downside, which seems a reasonable explanation for the market’s deep losses in early 2009. The rally since that point has cleared that oversold condition and then some. With earnings season winding down over the next two weeks, we are wondering what will be the driver for further gains in the near term? From our standpoint, after the significant bounce from the bottom we remain cautious of being overly bullish in a risky environment.
The percentage of NYSE stocks selling above their 30-week average price advanced to 88% as of the close of trading on Friday. The 30-week moving average is tracking back to the beginning of the year, so nearly 9 out of 10 stocks are trading for more than their year to date average. Considering the fact that the NYSE Composite is up about 13% since the beginning of the year, you can really see just how hot things have gotten recently. Investors should ignore this sentiment metric at their peril. We have seen this market drive sentiment to extreme levels over the last year, but ultimately there will be a reversion to more normal levels over the course of time. If one of the potential building blocks of recovery does indeed falter, such as the effects of continued joblessness on
the large amount of commercial and residential real estate debt coming due in the second half, sentiment could take a dive that will ultimately send stocks on another leg down.
If investors are interested in buying for the long term instead of trying to time the market’s action, we think now is not the time to be aggressive. Unemployment will likely continue to rise through the end of the year, with job growth beginning in 2010. Until that time it will be difficult for consumer spending to rise, which is a major portion of overall economic growth. Some analysts point to government spending as a driver of growth, while history suggests that the government cannot spur growth simply through increased transfer payments. For the long-term investor, aggressive buying at this point would require a disregard for some major headwinds to growth.
We often refer to one of the brightest market strategists, Dr. John Hussman who writes a weekly market comment. Here is a portion of what he wrote this week:
“Investors can point to various indicators that “flashed buy signals” near the March lows. The problem is that many of those also went positive during during last year’s plunge and then failed spectacularly (as also occurred in late January). More importantly, we can’t find factors that would have made us more constructive since March and that would also have improved long-term returns if applied consistently on a historical basis.
To remove our hedges here in anticipation of a sustained economic recovery and bull market would be to assume that the events in the economy since 2007 have been psychological and temporary, that there will be no material effects from continuing delinquencies and foreclosures (not to mention the second wave of reset pressures due to begin later this year), and that the Fed can create more base money in one year than in the entire history of the nation, without any consequence. If we could treat the recent downturn as a “standard recession,” that might be possible. But little is standard about this downturn, and the fundamental difficulties have deeper roots than trend-following investors seem to assume.”