The Enterprising Investor’s Guide 7-13-2009

The price-to-peak earnings multiple for this week is at 9.9x. The stock market has slowly trended downward for the last four weeks erasing about five percent of the recent rally’s gains. This weakness is a sign that the market must see sustained economic improvement in order to justify current stock valuations. We would not characterize the stock market as overvalued at present levels, but we are concerned that recent gains make it vulnerable to a correction if an economic rebound is not evident soon.

As our readers are well aware, we believe that the short-term direction of the market is not knowable because no one can consistently and accurately foretell the vagaries in investor sentiment that drive daily market movement. However, longer-term market valuation is firmly rooted in economic fundamentals–especially corporate profits. Earnings have been anemic for some time now and as of this week S&P 500 earnings are down 64% on a year-over-year basis, which makes the 29% decline in that index over the same time period appear somewhat subdued. Earnings season kicked off last week, but companies reporting this week will carry much more weight. Major financial stocks will be closely watched with Goldman Sachs (GS), JP Morgan (JPM), Bank of America (BAC) and Citigroup (C) all reporting. Other key releases will come from Johnson & Johnson (JNJ), Intel (INTC) and Google (GOOG).

The percentage of NYSE stocks selling above their 30-week moving average has declined fairly substantially to 69%. Investors who seemed more than willing to assume greater risk over the past few months are retreating to the safety of Treasuries and other low risk securities. This may suggest that a change in investor’s attitude has commenced as the rally was characterized by some of the riskiest stocks greatly outperforming the market; however, this has not been the case recently as investors have become less optimistic about a rapid recovery and have fled to safe alternatives. This skittishness has been reinforced by data from quite a few surveys of investor sentiment and consumer confidence for June.

As you can see from the chart below, there’s been a downturn in investor sentiment as the stock rally petered out. The previous rapid increase in our investor sentiment metric had made us skeptical of the sustainability of the rally. This sort of behavior makes recent gains more vulnerable than had sentiment risen in a more measured and methodical fashion. Volatility has taken a respite for about six weeks now, but we would not be surprised to it return with a vengeance as major earnings results are announced in the coming days.

We continue to advocate a reduced allocation to equities because stock valuations are not particularly attractive. The market’s valuation is not undervalued when compared to the extreme weakness in earnings over the past year and only appears undervalued when comparing it to the debt-fueled earnings levels prior to the recession. In addition, while investor sentiment is clearly in a downturn, it is still at lofty levels which prior to the this rally had not been seen in more than two years.

This rally is running on fumes and will need some strong earnings reports in order to reinvigorate it. The “better than expected” mantra has run its course (both because analysts have raised their estimates significantly from rock bottom levels and the market will demand more in order to justify the improved market valuation), and although expectations are still fairly low, some improvement is priced into the market already.

The Enterprising Investor’s Guide 7-13-2009

About Ockham Research 645 Articles

Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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