The price-to-peak earnings multiple has increased to 11.0x this week after two strongly bullish weeks. The market continued to advance with the boost of better than anticipated earnings results. There is no denying that corporate profits are better than the experts had predicted as nearly three quarters of companies reporting have beaten the Street thus far. 40% of the S&P 500 has reported already, and many more industry bellwethers are coming this week.
While the market has seen these “earnings beats” as a sign that the recovery has begun, we see reasons for real concern. As often happens, a cohesive theme has appeared in many of the earnings releases to this point: revenues have been pretty light but aggressive, and some would say draconian, cost cutting has enabled profits to remain afloat. Some corporations underwent major restructuring efforts when the market was in seeming free fall, and the cost cutting has begun to have the intended effect on the bottom line. However, companies can only cut costs so far, and sales growth is far better indicator of improved economic health. Economic indicators have begun to show improvement over the last three months, but leading economic indicators [LEI] are getting the biggest boost from gains in the stock market rather than from signs of sustained economic improvement that we would like to see from productivity, labor, construction data, and investment in durable goods. With the market’s valuation back to levels not seen since before the collapse of Lehman Brothers we are continuing to advocate a defense posture.
The percentage of NYSE stocks selling above their 30-week moving average has increased to 87% as of Friday’s close. This investor sentiment indicator has topped levels not seen in more than 5 years, suggesting a short term overbought condition. Investors have flooded back into stocks over the past few months under the pretense that the worst is behind us. The perception of a recovery has brought investors into the market in droves, and by this point many of the skeptics have been pulled in by fear of missing the gains.
For a long term investor, this is not the sort of market condition which should be attractive to buy into. Equities at these price levels are not particularly appealing; unless you think that corporate earnings will return to peak levels in short order, the risk is simply too great to justify the reward. We are not saying that the market cannot advance further because it has shown surprising resilience already, and of course there are undervalued stocks in nearly every market condition. However, to aggressively buy into the market right now is simply too risky for our investment strategy.
As readers have probably already surmised, our asset allocation model continues to suggest underweight equity allocation. That is not to say that investors should take drastic action and remove equity positions from their portfolio, but backing off exposure to stocks seems reasonable in this environment. The bullishness in the market may in fact be justified by the economic stabilization, but it would be a stretch to call this market undervalued given earnings have declined so massively from a year ago. Fund manager John Hussman Ph.D. has a unique way of visualizing present market conditions in his weekly market comment.
“It’s a lot like watching people scale across a tenuously secured rope bridge and get a nice meal at the center. You’d like to climb across and join them, but you know that too many things aren’t right with the bridge, and it’s not clear that the people who are eating will ultimately survive.
Our defensive stance here is driven by a combination of poor price-volume sponsorship, moderate overvaluation, strenuous overbought conditions, Treasury yield and commodity price pressures, as well as a variety of other factors that have historically combined to produce a weak overall return-to-risk tradeoff. Moreover, from a fundamental standpoint, the ebullience about an economic recovery is based on what I’ve frequently called the “ebb and flow” of short-term economic information that very well can turn hostile again – particularly given that there is no reason to assume that deleveraging pressures have seriously abated.”