The Enterprising Investor’s Guide 2-2-09

The price-to-peak earnings multiple declined slightly to 9.3x this week in keeping with the S&P 500’s drop of seven-tenths of a percent. This past January was the worst January ever for the S&P 500 after falling nearly 9%, erasing all gains made around the holidays to round out 2008 on a positive note. The market is above the lows set in October, but we would not be surprised to see the lows retested in the coming weeks, as earnings releases continue to be weak. Thus far according to our calculations earnings have fallen market-wide by 37.5% from peak levels thus far with further weakness expected. In addition, profit margins are declining at rapid rates as retailers and service providers are trying to attract buyers with deep discounts. The result is that equities will continue to struggle for quite some time, as the market tries to find the appropriate price level for the new earnings reality. Thus, the price-to-peak earnings multiple will assuredly not reach back to the 17x and 18x levels that we had become used to seeing in 2006-2007 for at least a few years. Investors are likely going to require a bit of assurance that earnings have stopped falling and are on the rebound before a significant recovery begins.

S&P 500

The percentage of stocks selling above their 30-week moving average has climbed back into the visible portion of our chart at 11%. This sentiment indicator has been extremely depressed for quite some time now; however, with the awful performance of equities in October, it is unlikely that this measure will substantially improve for another quarter. At that point, the October declines will be have been removed form this baseline sentiment indicator. That being said, as we already mentioned equities will continue to be squeezed for quite some time, so this situation is not a normal case where extremely bearish sentiment is a bullish indicator. It does not take a genius to see that this is truly a once in a lifetime market. In more traditional markets, the trends in this sentiment indicator can be much more informative, but it yields interesting data now nonetheless.

Our sentiment indicator is a fairly long term view of the market, but you can see that in the short term sentiment can swing wildly. As we saw last week, with financial stocks getting a major boost from the government stabilization “bad bank” plan. The passage of this plan through the house boosted the entire market, and especially financial stocks (some had huge gains). Then the market turned extremely negative as the bill was said to have difficulty in the Senate. The resultant downward swing took all those gains of the previous day and then some.


Our asset allocation model is reaffirming our bullish stance on the market from a long term value investor’s perspective. This asset allocation is based upon the combination of factors from the previous two charts. Under any normal circumstances, a value investor loves to get the combination of low marketplace valuation and persistently low sentiment as well. However, as we have stated earlier in the newsletter these measures will likely remain extremely low for a least the next quarter. So, while we think it wise to be cautiously optimistic about equities at these levels, we would not recommend buying any and all stocks simply because stocks look undervalued compared to historical norms. The reality is that some of the stocks that look the most “undervalued” may not make it through this downturn, at least not in their current form. We continue to advise, as always, that companies that are able to maintain or even increase earnings and revenue are as close to a safe stock as there is in this market, and those will be the first to recover as well.

Equity Allocation

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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