The price-to-peak earnings multiple has climbed to 10.6x in the last week. The stock market’s recovery from what appears to have been the bottom in March has brought the S&P 500 up nearly 40%. In the last 14 weeks, only one week has seen a sell off of any significance. When this all began it was primarily because of speculation that first quarter earnings from major banks were going to be much improved over the record losses of the 4th quarter 2008. Last week, the Treasury allowed ten banks the opportunity to repay the TARP funding they had received (Ten Banks Eligible to Pay Back TARP…Really?), as the last few months has seen many of these banks able to raise capital through private channels such as secondary equity and debt offerings.
There is no doubt that the banks, the Treasury, and investors in this market are signaling a belief that the worst is behind us. We hope that they are right, but with the market no longer cheap (unless you believe that a quick return to 2007 corporate profits is in fact attainable) we think caution is warranted. We have often noted that the “green shoots” that everyone was counting on have been rife with the term “better than expected”, there is only so long that this will carry water. Real improvement in the economy will be necessary to sustain the gains already achieved. Now more than a quarter of the way into recovery in stock prices, second quarter earnings are right around the corner in July and should give further insight into where the financial sector stands.
The percentage of NYSE stocks selling above their 30-week moving average is 83.7% as of Friday’s close. Our sentiment indicator is at very high levels, as the last time this indicator was in the 80% range was back in February of 2007 and the last time it was higher than it is today was in April of 2004. There have been signs of improving sentiment throughout the economic landscape over the past few months. Consumer sentiment has risen significantly, but this has been over-hyped as consumer spending has actually fallen year-over-year for the first time in history. Investors have shown an increased appetite for risky investments, as some of the best performing stocks have been the ones with the most troubled balance sheets. Stocks have enjoyed a nice rally, while Treasury debt (heretofore known to be a safe haven) has seen a back-up in rates in order to entice buyers.
Perhaps most importantly has been the ability of firms to raise capital and the re-emergence of the IPO. This is a development that everyone should be able to cheer as it has allowed many firms to return the taxpayer funded TARP funds back to the Treasury, so far about $68 billion. That is a minute portion of the overall growth in the balance sheet of the Treasury, but it is a major step in the right direction.
The market has returned to the level where it was in the aftermath of the collapse of Lehman Brothers, and we are not positing that the market cannot continue to climb higher. We are however seeing that the recent gains in equities are vulnerable and buying into the market right now is not defendable based on market valuations. Certainly, there are individual stocks that still are a worthwhile investment, but overall the market is overbought and we think a retracement is more likely than not. The recent gains in the market simply have not yet been justified by corresponding improvements in corporate earnings.
As frequent readers are aware, we will sometimes rely upon the wisdom of Dr. John Hussman to clarify a point, this quote is taken from his weekly market comment:
Until now, “less bad than expected” has been enough for investors. As a friend of mine quoted last week from a song by The Doors, “I’ve been down for so long, it feels like up to me.” At this point, however, stocks are priced to require an economic recovery. That is a difficult bet, in my view, because as I noted last week, economic expansions are emphatically not driven by a “consumer recovery.” They are invariably driven by swings in gross domestic investment – capital spending, autos, housing, factories, and other outlays that are heavily reliant on debt financing. That’s why housing starts have such a strong correlation with GDP growth.
It is a very hard sell to expect a sustained recovery in debt-financed gross investment in an economy under strong deleveraging pressure. That’s particularly true since the U.S. itself has not financed a penny of the growth in U.S. gross domestic investment in more than a decade – all of the growth has been financed by foreign capital inflows via a massive current account deficit.
With government spending now drawing on those foreign savings to defend bank bondholders from losses, and a continuing need to shrink the current account deficit in the years ahead, gross domestic investment is likely to continue to be squeezed. We are in the midst of – and will continue to require – perhaps the largest adjustment in U.S. personal, corporate and government balance sheets that we will see in our lifetimes. This will be a very long slog. The outlook is not up, but very widely sideways.