The price-to-peak earnings multiple declined to 10.0x this week. The S&P 500 lost about 2.5% last week, extending the current losing streak to three weeks in a row and erasing about five percent in value from the index. The market appears to have reached a ceiling on “the worst is behind us” rationale and will now require clear improvements in underlying economic fundamentals in order to justify higher stock valuations.
On that note, second quarter earnings season gets underway this week, beginning as usual with Alcoa (AA). Chevron (CVX) is the other big release this week. There are other, more important earning releases scheduled for next week, but it is always helpful to have things start off on the right foot. The week ahead will be relatively light in terms of macroeconomic data, which is likely a blessing considering that employment results for May were 100,000 jobs worse than forecast, which greatly disappointed the market last week.
Overall, we are very cautious about investing in the market right now because valuations are not particularly attractive, unless you believe that earnings will quickly rebound to the levels achieved two years ago, a large percentage of which were from highly levered financial earnings. We are hopeful that earnings will improve steadily over the next quarter or two, but that is not a foregone conclusion.
The percentage of NYSE stocks selling above their 30-week moving average contracted to 76% this week. Sentiment had rocketed up to extremely high levels based solely on investor hopes for a quick recovery. The rapid pace of improving sentiment makes it hard for the market to sustain such a rally as expectations are likely too high and probably unrealistic. We are now seeing those high expectations wear off and reality setting in. The problems of rising unemployment and continued misery in both commercial and residential real estate are persistent reminders that it will take more than “better than expected” economic news to justify investor optimism going forward.
Mark Hulbert editor of the Hulbert Financial Digest, a survey of investment newsletters, was interviewed on CNBC Monday morning and he said that the sentiment we are talking about is not uncommon among newsletter publishers. In the past three weeks the market has pulled back slightly, meanwhile investment newsletters have become decidedly bearish. Market observers are certainly becoming more worried about the potential risk in this market where valuations are not particularly attractive and sentiment appears to be in decline. Also of note, the widely-followed Hulbert was not willing to concede that we have already seen the bottom in this cycle. As a contrarian, the extremely rapid rise in sentiment tells him that we never reached the true “revulsion” phase, where the majority of investors given up on stocks and recovery is not widely predicted. Instead, the market has shown quite the opposite, a willingness to bear more risk based on little more than apparitions of “green shoots”.
We have said in previous newsletters and continue to believe that the next couple of weeks will be a major indicator for the rest of the summer as earnings results test the “green shoots” thesis yet again. Of course, we are not going to predict where the market is headed in the near term, but the still-very-high sentiment levels are reason for concern. Investors are weary of hearing that things are improving while seeing no tangible evidence to support it and must now see recovery with their own eyes. There are plenty of challenges ahead, chief among them in our opinion, will be climbing unemployment– already at 25 year highs–and its resonating effects on housing, consumer spending and consumer credit. At current levels, we do not see an appropriate risk/return profile to advocate loading up on equities.