The price-to-peak earnings multiple declined in conjunction with the market last week to 11.4x. This valuation metric does not suggest an extremely expensive market, assuming that earnings quickly recover to levels seen in the summer of 2007. Typically, we have believed that any time stocks trade below 12 times peak earnings, it is reasonable to become more aggressive in buying stocks. However, we are skeptical that those record corporate profit margins (largely due to debt-enhanced financial returns) will be repeated anytime soon. There are many headwinds facing the economy right now, despite all the talk of stabilization.
When you look at the market’s valuation using operating earnings instead of peak earnings, it is not attractive in the slightest. According to Barron’s, the S&P has a multiple of 128.7x when using operating earnings for the past twelve months. At this lofty level, a value investor should see major cause for concern. We would expect this metric to improve over the next two quarters as there will surely be less write-downs than we saw a year ago. There has been tremendous margin expansion over the past six months but earnings are still far from impressive.
The percentage of NYSE stocks selling above their 30-week moving average is down to 89% as the close on Friday. Investor sentiment remains firmly bullish, but there are signs that this ebullience is on the wane. For one thing, investors have recently flooded into the safety of gold. On Tuesday, the price of gold broke through the psychological boundary of $1000 per ounce. The source of increased demand has almost entirely come from investors rather than consumers of jewelry. For a graphical representation of this flight to safety, Clusterstock’s Chart of the Day from last week shows the money flowing into gold ETF’s has been impressive. An investment in gold does not necessarily mean that investors are bearish on the stock market, rather it is more likely being used as a hedge against inflation. However, we view this development as defensive in nature, as gold and precious metals are seen by many as a safe haven.
While we are not discounting the possibility of a continued bullish streak in the market, we do advise a less than normal exposure to equities. With sentiment solidly bullish and the market’s valuation unattractive, we are proceeding with caution. We believe that there are undervalued stocks in nearly any market, but if stocks do experience another leg down, better entry levels will await those who are patient. From our view, the market is overbought and due for at least a small pullback.
