The Enterprising Investor’s Guide 6-1-2009

The price to peak earnings multiple advanced to 10.3x as of the close of trading in May. The stock market’s three month rally has been the strongest for the S&P 500 percentage-wise since 1938. Prior to the rally, stock valuations were extremely depressed, but the strength and particularly the breadth of this rally has been truly remarkable. All the while, the underlying economic data has been inconclusive at best, yet the ebullient market reaction is simply reflective of customary investor psychology that the worst of the recession is likely behind us. One analogy that can be made to this “relief rally” is that the market has held its collective breath since the fall of Lehman Brothers in September. With recent bank earnings outpacing even the most optimistic of expectations, the market is finally exhaling and starting to breath again.

As we have continually stated over the last few weeks, this rally has passed the point of just a clearing rally from a oversold market condition. The market appears to be trading less on fundamental factors than on hopeful sentiment that growth is right around the corner.

S&P 500

The percentage of NYSE stocks selling above their 30-week moving average is 79.9% as of last week. The rapid increase in investor sentiment has been remarkable and has fueled the stock market’s rise more than any other factor. As described in greater detail in our blog post (Sell in May, Not This Time), sentiment is a completely legitimate reason for the market to rise but it is also true that sentiment can be a fickle thing. If there is “irrational exuberance” in the market, then any impediment to economic growth can rapidly reverse any recent gains and send stocks into a potentially serious decline. The market is undoubtedly hot right now, but it must be viewed in the context of its risk/reward profile. Stocks could continue to charge ahead at a steady clip, with their climb hopefully matched by a simultaneous rise in the under-girding economic fundamentals. However, investors will need to see signs that corporate earnings are improving because the “less-bad” or “better-than-expected” justification can only go on for so long.

One thing to keep an eye on is the situation last week in Treasuries. Trading in government debt was more volatile than usual, as the 10-year Treasury yield spiked to 3.75% on Thursday. The U.S. government is printing money at an break-neck pace and has actually doubled the monetary base in the past year. There are small signs that the number of investors willing to absorb infinite quantities of our debt are dwindling–thus the steepening yield curve. Inflation has yet to take hold because monetary velocity is still depressed as the domestic personal savings rate hit a 15 year high. However, it is clear to us that when economic activity does pick up, velocity will as well and the massive expansion of the government’s balance sheet will result in inflation, or possibly even hyper-inflation, if the Fed does not apply the brakes at the right time.


The event that nearly everyone saw coming months ago has finally happened: General Motors (GM) has filed for Chapter 11 bankruptcy protection. One of the most iconic companies in American business will now have a chance to reform itself (with the help of more tax payer funding of course). The fears that filing for bankruptcy would destroy the brand have been thus far shown to be incorrect by Chrysler, who is reporting increased traffic in its showrooms since it filed for bankruptcy. There is little chance that the bankruptcy will lead to large increase in sales in the short term, but it will undoubtedly help bring the cost structure under control. Because this filing has been expected for so long, the market priced in this possibility long ago. Today’s GM news did change the face of the Dow Jones Industrial Average as Cisco Systems (CSCO) will replace GM and Travelers (TRV) will replace Citigroup (C).

The Enterprising Investor’s Guide 6-1-2009

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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