The price-to-peak earnings multiple continued to advance to 13.2x as of the close of trading last week. Equities closed out the first quarter in strong fashion, posting five straight weeks of gains. After a rough start to the year, the S&P 500 rebounded impressively in March to post a 5.4% return for the first quarter of 2010. Earnings should be in a holding pattern for the week ahead as Alcoa (AA) will unofficially kick off the latest round of earnings season next week. The break between quarterly earnings reports is a opportune time to review where we currently stand.
Our weekly valuation chart shows how the S&P 500 is positioned compared to peak earnings multiples. We use peak earnings rather than current earnings in order to normalize the volatility inherent in corporate earnings results. Recently, earnings have have fallen far short of the S&P 500’s peak earnings level of $89.22 which occurred in the summer of 2007. Keep in mind that those earnings were achieved thanks to huge leverage boost which produced profit margins nearly 50% above their historical norms. Today, trailing twelve month earnings results for the S&P 500 have normalized to $49.92, a P/E ratio of 23.6x. This is a tremendous improvement from last year’s trailing earnings trough of $9.96 which occurred at the end of October 2009 (thanks to massive asset write downs during the previous year) and most analyst now predict S&P 500 earnings for the full year 2010 will be between $75 and $80.
Today, investors are confronted with a conundrum presented by two data sets: forward looking estimates and trailing twelve month estimates. Assuming that analyst projections are correct for the year ahead, the forward looking earnings multiple is a bit more than 15x, which for a long term investor is a fairly average multiple to have to pay for forward earnings. If one thinks that the recovery will be more robust than current projections, stocks have room to continue their advance. On the other hand, we are not convinced that earnings will continue their steady improvement to pre-recession levels. As such, we do not see the market’s current valuation as compelling for long-term investors.
The percentage of NYSE stocks selling above their 30-week moving average has grown to nearly 79% . The sentiment chart below suggests that the market is again heavily overbought as the rally continues. Sentiment remains quite bullish and received a boost last week from the March jobs report. The data was not as good as many of the economists forecast, but it did show the most job growth in about three years. Jobs are a lagging indicator and the fact that companies are finally hiring more workers than they are firing is confirmation that the economy has begun to heal. That being said, more than 8.4 million jobs have been lost in the Great Recession and it will be a slow and arduous process getting the jobs back. Measures of productivity stand at their highest levels in years, and mangers are doing their best to employ the workforce they have before additional hiring. Profits have been boosted by heavy cost cutting and job losses over past months and we expect permanent hiring to be positive yet tepid in the coming months as companies work to maximize profitability.
Financial pundits and analysts continue to be hugely divided between bullish and bearish arguments, as all around us there is evidence to support both viewpoints. We do not believe that stocks are doomed to repeat a sell-off as severe as the crisis that we saw in late 2008 and early 2009. However, we remain mindful that current conditions warrant caution for long-term investors. Historically speaking, a market condition that includes unfavorable valuations, highly bullish sentiment, overbought stocks and rising interest rates has not been a good market environment for long-term investors to buy. In such a risky environment, we tend to recommend shifting allocation to more stable, dividend paying stocks. Stocks that pay a generous dividend have a built-in margin of safety that is always attractive to us, but never more so than in such a market condition as the one we’re in. Of late, the market has achieved small but steady marginal gains. Remember the old adage, “the trend is your friend; until it isn’t.” Our asset allocation strategy recommends 90% of your portfolio’s normal allocation to equities is appropriate right now.
