The price-to-peak earnings multiple fell back to 10.0x as of Friday’s close. In the first full week of trading in 2009, the tentative year-end rally came to a screeching halt as the S&P 500 dropped 4.5 percent. From a macro-economic standpoint, there is little doubt that at least the first half of 2009 will be a very challenging, as de-leveraging of the financial system continues. De-leveraging is necessary in order to restore a healthy economy as our ratio of debt-to-national income has climbed to huge levels and currently stands at 360%.
Debt had fueled much of the growth over the past decade or so, especially in the financial services industry, and that spigot is currently all but shut off. Debt magnifies returns both on the positive and, unfortunately as we are seeing now, the negative side of the equation. The impact of this de-leveraging will likely be a prolonged period of less-than-optimal growth. However, in our view, the process of wringing-out excess leverage has been largely priced-in to the market at current levels thanks to last year’s brutal performance. Remember that the stock market is forward-looking and often recovers up to six months prior to the economy in general. This recession is already one of the longest since the Great Depression, at 13 months and counting. We could see a recovery in the stock market in the next few quarters, even as the process of de-leveraging continues unabated.
The percentage of NYSE stocks trading above their 30-week moving average is 9.7% this week, again just below our 10% (extremely bearish) sentiment threshold. This sentiment indicator has been below 10% for three full months now; normally it is rare for this indicator to drop so far even for a week or two. This sentiment indicator is a contrarian measure that is generally lowest at market bottoms and highest at market peaks. Repeating what we have said in the last few newsletters, this condition is not sustainable and sentiment is likely to revert to more normal levels at some point. Furthermore, here is some additional sentiment data to back up our indicator. First Coverage Market Sentiment which tracks sell-side analysts shows an overall bearish tone with zero bullish sectors, four neutral sectors and six bearish sectors. The American Association of Individual Investors (AAII) reports that the number of investors who are now bullish fell to an extremely low reading of just 24%, expanding its bull/bear spread to -31%. Any sentiment indicator one observes at present points to the same conclusion, as Russ Koesterich, head of investment strategy for Barclays Global Investors was quoted in the WSJ last week:
“If you look at any measure of investor sentiment, people are still very pessimistic. There has been a lot of focus on a stimulus package, but it’s not clear what the short-term impact would be. The economic data will likely continue to get worse before it gets better.”
Our asset allocation model continues to advocate exposure to equities for the long-term investor. As we have noted, it could be a fairly bumpy ride over the next few months but stock investors are finally seeing valuations at reasonable levels once again. Essentially, we have thought that the market was overvalued by varying degrees since the late 1990’s, reaching absurd levels in early 2000 and returning to exceptionally rich levels in 2007. Valuations are now defendable as the market has fallen rapidly in the face of a very challenging environment. However, investing in this climate requires discipline as volatility will likely continue to be high. As stocks falter, value investors must not lose their nerve and lock-in losses by selling into weakness. But, when volatility is to the up-side, investors should be content to take modest gains of 10%-15% instead of letting those profits ride in this risky atmosphere.