The price-to-peak earnings multiple was 10.5x as of the close of trading Friday. Last week saw a strong reprieve from the previous four weeks of losses, and the S&P 500 climbed 7% on some headline earnings that beat the analysts predictions. Earnings season burst onto the investment landscape last week, and the results were generally positive. Last quarter’s earnings season could be characterized by the phrase “better than expected,” as most companies were able to beat estimates that had fallen dramatically. If the first week of second quarter profit announcements is any guide, then we believe this quarter will be characterized by cost control, as profits are beating estimates while revenue continues to be a drag. Just last week we saw that happen with; International Business Machines (NYSE:IBM), Google (NASDAQ:GOOG), Yum! Brands (NYSE:YUM), Gannett (NYSE:GCI) and Nokia Corporation (NYSE:NOK). All of those firms experienced difficult sales environment in the last quarter, but most were able to improve margins and some even exceeded estimates even as sales fell.
Corporations have become leaner through this recession, which is good news for the market as improved profitability is always a welcome development. This trend of minimizing costs will likely continue as long as sales are under pressure, and this is more bad news for the unemployed. One of the most common ways that a company can lower costs is through headcount reduction. Last week’s strong performance aside, we continue to be concerned about market valuation. Equities have been pushed up on relatively little improvement in the fundamentals and could be vulnerable to losses going forward.
The percentage of NYSE stocks selling above their 30-week moving average is 82% this week. In just one week our metric for investor sentiment has recovered from its steady decline to near multiyear high levels. Prior to recent the recent rally, it had been about 5-years since we have noted such an enthusiastic market sentiment level. The recent advance was unique because it achieved extremely high levels extremely quickly after suffering at multiyear lows just weeks before. Whenever a clear consensus has been reached by the investing “crowd” our contrarian nature starts to make us more than a little skeptical of what it seems “everyone knows.”
Interestingly, two of the biggest swings in sentiment last week came not from positive earnings or macroeconomic trends, but instead from the opinions of two high powered analysts. On Monday, Meredith Whitney came out very bullishly recommending Goldman Sachs (NYSE:GS) prior to earnings. The market latched onto her bullishness on Monday and the market advanced 2.5%, on nothing more than her changing opinion! Thursday a very similar event occurred when the equity markets took off, on what was interpreted at the time to be a bullish statement by permabear Nouriel Roubini. Roubini has since rejected the notion that he is optimistic on the market, and claims that his statement was misinterpreted. I bring this up to demonstrate that the market is trading on emotion more than fundamentals for the time being. Nothing of material interest had changed with these two instances except for the perceived sentiment of two superstars. In a market looking for direction, this was all of the inspiration it needed for large advances. (A Week of Superstar Bears Moving the Market)
At Ockham, our asset allocation model has downshifted to our lowest equity allocation target for an investment portfolio (containing equity, fixed income and cash). The combination of somewhat unattractive valuations and extremely positive sentiment is not a risk/reward profile that we find appealing. That is not to say that this market will not continue to advance, and we are not advocating taking all of your equity exposure off the table. Rather, we are in favor of is a more defensive allocation with about 75% of your normal equity allocation.
Simply put, the economy has recovered from the brink of disaster but there are still major challenges to growth ahead. The stock market was very oversold in March, but has since cleared that condition and then some. We have been saying for weeks that–by virtue of the recent rally–the market has priced in a fair amount of improvement already. Any disappointment in the progression of economic recovery could snuff out the sentiment fueled rally.