For the third week in a row, U.S. equities proved fairly resilient in the face of negative economic news as stocks finished the week almost flat on Friday (for more see this post When All News Is Bad News). The price-to-peak earnings multiple remains at 9.8x, which is the same as last week. This valuation indicator is unchanged simply because the S&P 500 price level slipped only .28% last week, and peak earnings were set in August of 2007 and currently are only two-thirds of this peak level.
In general, valuations remain favorable but since the market has actually recovered nearly 21% since its November low, it is harder to argue that the market is oversold, at least over the short-term. On the whole, we do think that long-term investors should be looking to establish positions right now but caution is warranted as it is very possible that we could see another stock downturn before a sustainable recovery truly manifests itself.
Sentiment is still exceedingly bearish based on the percentage of NYSE stocks selling above their 30-week moving average, which is unchanged at just over five percent. It is easy to see why there is much skepticism on the part of investors right now. The uncovering of Bernard Madoff’s gigantic Ponzi scheme last week presented yet another enormous shock to the system. What could become the largest financial scandal ever is both stunning in scope and is another in a long line of negative news that investors must contend with at present. Markets also were spooked by the tug-of-war on Capitol Hill over the auto bailout. And stalwart companies such as Texas Instruments (TXN) and FedEx (FDX) are lowering their future guidance while Bank of America (BAC) plans to axe another 35,000 jobs. However, the constant drumbeat of negative news is not generating the furious panic selling that we saw week after week in November. There is a point where investors become sated with bad news and, like an over-saturated sponge, additional bad news has little to no impact. Instead of panic selling, what we are observing is a flight to quality as U.S. Treasury prices gained for a sixth straight week. For example, the yield on 10 year U.S. Treasury Notes reached a intraday low on Friday of just 2.47%, its lowest level since 1954!
As you will notice, our asset allocation model remains at its most bullish level, which can be unnerving in these tough economic times. From a valuation standpoint, this could be a once in a lifetime buying opportunity but, from a fundamental standpoint, the world faces a prolonged economic downturn as global de-leveraging works itself out. Perhaps we are headed for a paradigm shift where leverage-inflated earnings are a thing of the past and there is a prolonged period of slower earnings growth. While valuation models may still be overly optimistic based on market experience conveyed during the past 30 years, we believe that market valuations do matter and that the sell-off in stocks over the past year coupled with almost eight years of little to no appreciation for the major stock indices, have uncovered compelling values for patient investors. Remember when stocks were setting record highs in 2007, we urged extreme caution as the markets were overvalued and would not stay that way. (Essentially valuations were not favorable for long-term buying.) The fact that valuations have returned to what we consider to be attractive levels coupled with overwhelmingly bearish investor sentiment makes it a good time for those investors who have the discipline to adhere to a value investing strategy to be cautiously establishing new positions.