The price-to-peak earnings multiple is up to 9.6x this week. As we have noted often, this valuation measure is being calculated against peak earnings that were reached at the height of the credit bubble in the summer of 2007. Nearly two years after those record earnings, the bubble has burst and–by our calculation–earnings have fallen by nearly two-thirds with the vast majority of those earnings declines in the last year. We are continuing to advocate a cautious view of the price-to-peak earnings multiple in this instance. It would be foolish to say that earnings will never breach the current peak levels, but it may take a significant amount of time. Earnings season kicked off in earnest last week, and there are even more big announcements coming this week. After the recent market advance, equities appear to be much more in line with historical fair value rather than the undervalued stance we have had on equities for the last few months.
The percentage of NYSE stocks selling above their 30-week moving average is 41% this week. Our sentiment indicator is up quite a bit recently, as the market has enjoyed five straight weeks of advances. However, these advances, while certainly overdue, have been reached on weaker than normal volume. This suggests that instead of the market rallying behind the idea of recovery, it was more of a clearing of an oversold condition and there was some short covering as the market began to rise.
You can sense the change in sentiment from a variety of sources. Television pundits, who just weeks ago were predicting the Dow would fall to 5000, are conducting interviews about the best ways to play the recovery. A recent survey of financial advisors shows that the tide has turned and now more than half are bullish for the year ahead. We are very careful not to get caught up in the crowd claiming the bottom has been set. There are still many unresolved issues that are going to crop up over the coming months, including a large wave of mortgage resets and commercial real estate will likely come under increasing pressure, and it just seems like investors are far too willing to put healthy skepticism aside for fear of missing the rally.
As you have probably ascertained, we are very skeptical of this rally. There has been a trend of macro economic results beating much lower expectations in the past few weeks, but very little in the way of concrete evidence that the problems that brought us to this point have been resolved. While the market has appeared to be particularly oversold for the beginning of 2009, a rally to clear that condition does not necessarily mean that the stock markets have already put in their lows.
Our position on the matter was strengthened through a careful reading of Dr. John Hussman’s Weekly Market Comment. Dr. Hussman has been described as a perma-bear (at times overly bearish), but he is one of the brightest economists and writers today and he lays out his arguments in a very clear way. We suggest you read the entire article but here is an important segment:
“Strong intermittent advances are typical during bear markets, and can often achieve gains of 20% as we’ve seen in recent weeks, and sometimes substantially more. But the very existence of bear market rallies can be a problem for investors, because they clear the way for fresh weakness. The scariest declines in bear markets are typically the ones when investors think they are making progress and recovering their losses, only to see stocks go into a new free-fall.
“That cycle of decline, followed by hope, followed by fresh losses, is really what ultimately puts a final low in place. The final decline of a bear market tends to be based on “revulsion” – a growing impatience among investors who conclude that stocks are simply bad investments, that the economy will continue to languish, and that nothing will work to help it recover. Revulsion is not based so much on fear or panic, but instead on despair and disillusionment. In a very real sense, investors abandon stocks at the end of a bear market because stocks have repeatedly proved themselves to be unreliable and disappointing.”
Could the final low of the bear market be in place? Sure. But even if that were the case, it does not follow that the markets will recover their lost ground quickly, and it is particularly dangerous to believe that the major indices will not meaningfully retest (if not substantially break below) the prior lows.