The price-to-peak earnings multiple climbed to 9.4x this week. Stock’s recent four week rally provided a welcome respite from the bear market and all major indices are up nearly 25% from their March 9th lows. The rally has been fueled by data suggesting that the domestic economy is stabilizing. Financial stocks have been at the forefront of the rally because of speculation that many may turn a profit in the first quarter. In addition, last week the Financial Accounting Standards Board (FASB) announced the relaxation of mark-to-market accounting rules. In our view–this is a positive development–but in the end it is only an accounting change and does not diminish the realities of the damaged assets weighing on the balance sheets of financial companies. The new rules will give banks more leeway in determining an appropriate current market value for their assets, which in some cases may be very worrisome. Some have called the changes “window dressing” and while it is true that accounting changes do not create value, the FASB’s move will be helpful as massive asset write-downs will undoubtedly be less likely going forward.
As for valuation, we continue to believe that–from a long-term perspective–equities remain relatively undervalued. Due to the strength of this four week rally, over the near-term we would be cautious about buying too aggressively. The underlying conviction of this rally will be tested over the next few weeks as we enter what is likely to be a very bleak earnings season. Investors will be looking to confirm the trends of stabilization–particularly in the financial and retail sectors of the economy. If earnings are anything like Research in Motion’s (RIMM) were last week–they blew away expectations and offered a rosy outlook for the next few quarters–then we would expect the rally to continue. However, matching-RIMM will prove very difficult for most companies, especially in this environment.
The percentage of NYSE stocks selling above their 30-week moving average rose to 34% this week. The rapid appreciation in our sentiment indicator yields a couple of interesting observations. First, by virtue of the markets being depressed for so long, it only took four weeks of positive weekly returns to bring the sentiment indicator back to its highest level in eight months (since the second week in September). Second, in this four week rally, we have come from the depths of sentiment (which to us is a bullish indicator), all the way up to levels we would consider neutral. The fact that more than one-third of NYSE stocks are now selling above their 30-week moving average and that stocks have risen so sharply suggest that the market is overbought, near term. So, value investors should beware of a pull-back in shares as investors take some money (dare we say profits?) off of the table.
As stated before, we are skeptical about the recent rally but learned long ago “don’t fight the tape.” The price-to-peak earnings multiple continues to look relatively benign, but considering that the peak earnings number is based on record earnings from 2007 which were artificially inflated by a credit environment which no longer exists, we might have to view this indicator with a grain of salt. That being said, we expect that going forward the price-to-peak earnings multiple will likely remain lower than the level we had become accustomed to observing. In the past, we considered a peak earnings multiple somewhere between 12x and 15x to be a “Fairly Valued” market. Going forward, we will need to relax that standard somewhat because peak earnings are not going to be reset for some time.
Valuations are not as cheap as they seem at first glance and sentiment levels are advancing quickly. Thus, it is no longer as attractive a time to increase your exposure to equities. That being said, we do not advise that you go against bullish momentum in stocks and sell out. The market seems to be at a tipping point and the corporate earnings reports over the next few weeks will tell a lot about the direction we are headed. Some key reports to look out for: Alcoa (AA), Mosaic (MOS), Family Dollar (FDO), and Chevron (CVX).