The price-to-peak earnings multiple increased to 11.7x as of Friday’s close. Stocks resumed their advance as a number of Wall Street analysts increased estimates for major U.S. firms including Apple (AAPL), General Electric (GE), Motorola (MOT) and Tiffany’s (TIF). Over the last two quarters, most companies have beaten their vastly reduced estimates, despite reporting numbers that would have been considered quite weak compared to those of 2007. Companies have gotten much better at managing expectations. As for the “thundering heard” of Wall Street analysts, in general they were overly bullish on earnings forecasts leading into this maelstrom and they now seem to be overly bearish on earnings in the current economic environment. Is it any wonder that market valuations may have gotten ahead of earnings expectations?
We believe that analyst estimates do need to be raised, as economic conditions have stabilized and in some cases are improving and the companies that have survived the Great Recession are lean and mean and face reduced competition from weaker competitors who did not survive the downturn. However, we do not expect that earnings will quickly return to the highs of the summer 2007. The past year’s reported earnings give a skewed picture of valuation (with a current P/E in the 120’s) because they include massive write-downs which are extremely unlikely to be repeated this year. Looking at operating earnings we get a better idea of valuation which, according to Standard & Poor’s, suggests that the multiple (based on earnings estimates for the end of the third quarter (9/30/09)) will be 27x. This is certainly not cheap and shows that a substantial amount of earnings improvement has already been priced into equities
The percentage of NYSE stocks selling above their 30-week moving average has advanced to 91% thanks to a bullish, holiday-shortened trading week. Sentiment remains at extremely lofty levels by this metric, but there are others which suggest that bullishness has peaked. For example, the AAII survey of individual investors shows that bears are more prevalent by a margin of 44% to 37%. Also, sentiment among investment advisers has shown growing skepticism over the durability of the now more than half year long rally.
Perhaps the most well informed investors of all are overwhelmingly in profit-taking mode. Corporate insiders are selling their own corporations’ stock far more than they are buying (Pace of Insider Sales Continues to Escalate). While insider selling can have many causes, it is normally a sign that “smart money” is concerned about overall stock valuations.
Not surprisingly, our asset allocation model suggests that investors should have less than their normal allocation to equities at this time. There is significant risk in a market in which valuation is unfavorable and sentiment is extremely positive. EIG readers over the last few months might be growing tired of this sort of reasoning, but investing with discipline is of extreme importance. Although, we may miss out on a few points of return here or there, we believe that we are in an economic environment where preserving capital is the first priority. We do not advocate completely selling out of equities and we cannot predict the future, but the risk is too great to “swing for the fences” at present.
