The price-to-peak earnings multiple increased to 11.5x, as of the close of trading on Friday. Equities continue to become more pricey (52% higher than the March lows), even as the underlying fundamentals show merely stabilization rather than signs of strength. Stock indexes advanced strongly on Friday, as Fed Chairman Bernanke made encouraging remarks that they economy is surely improving and a growth trend is looming. Interestingly, his predecessor has a much more cautious view, saying: “We’re okay for the next six months. We are getting a recovery… but the process doesn’t have legs to it.”
We maintain that the market is no longer attractively priced at current levels and equity investors have been too quick to believe that stabilization equals sustainable growth. We are willing to concede that GDP figures will likely turn positive in the third and fourth quarters. However, that growth is attributable to government spending, stimulus efforts like “Cash for Clunkers” and a subdued inventory restocking phase. This is not the most impressive or sustainable model for economic growth.
Furthermore, the market has now priced in substantial improvement and upside surprises will be harder to produce. The strength of the rally has been extremely impressive, but for a long-term investor, we recommend patience and extreme caution until more appealing valuations materialize.
The percentage of NYSE stocks trading above their 30-week moving average reached 90.5% last week (see chart below). Our sentiment metric has climbed to levels that are literally “off the chart”. We are always skeptical of a school of thought that is revealed so prevalently. When the “conventional wisdom” reveals itself as clearly as it has this week, we would generally see a tremendous opportunity as a contrarian. This sentiment indicator only contributes to our overall opinion regarding equities that it is best to lessen one’s exposure in circumstances such as these.
While there is no law that would prevent equity valuations from to continuing to rise, we think it a risky proposition to increase one’s allocation to stocks in this environment. The key to an appropriate asset allocation strategy is determining one’s correct risk/return profile. We believe that when sentiment indicators are overwhelmingly bullish and valuation is not particularly attractive (unless you anticipate a quick return to peak earnings levels), there is ample reason to be concerned. Not surprisingly, our asset allocation model has indicated our most defensive allocation stance for the past four weeks. Predicting the short-term movements of the market is impossible to do with accuracy but we believe that over the long-term, fundamentals such as earnings are the driver of market returns. This rally has been lacking in fundamental strength and the possibility of a W-shaped recovery appears increasingly likely.