The price to peak earnings multiple was 10.5x as of Friday’s close, its highest level since October of last year. The stock market’s virtually uninterrupted advance has brought overall valuations to a level that few expected to see so quickly. The price-to-peak earnings multiple compares current earnings to peak levels from 2007–a period when systemic leverage created supercharged earnings that will be virtually impossible to replicate going forward. We use this measure because it serves to smooth the data, since earnings numbers can actually be more volatile than stock prices. Smoothing out this valuation metric makes it easier to compare earnings levels over various time periods. If the leverage-inflated corporate profits of 2007 are not likely to be seen for at least the next few years, an adjustment or caveat to the use of this metric seems to be in order. In the chart below, the orange grid line represents what has traditionally been regarded as the S&P 500’s “normal” valuation range. In this exceptional environment, we are ratcheting down the price to peak earnings multiple that we consider “normal”.
Let us compare the peak earnings multiple to the current earnings estimates for the S&P 500. At peak earnings in August of 2007, we calculated earnings on the S&P 500 to be $89.20. At that time the, the index’s price level was in the 1470s, just a few percentage points off its all time high. At that point the price to peak earnings appeared overvalued at 16.5x. Since that time, corporate earnings have eroded considerably to the point that Barron’s latest calculation of S&P 500 earnings is just $7.21, which, with the S&P 500 at 940, would make its current P/E a monstrous 130.4x. Since stock returns over time are driven by increasing corporate earnings, it is imperative that investors become more cautious in periods where the earnings multiple is inflated. While the current market multiple looks interesting compared to where it peaked out, given the extraordinary circumstances we now find ourselves in, caution is advised on the long side of this market.
The percentage of NYSE stocks selling above their 30-week moving average is 84% this week. We have observed a striking and steady march upward in this sentiment metric. The strength and importance of the sentiment indicator cannot be overstated since clearly the recent stock rally has not been driven by an improvement in underlying market fundamentals. This rally has been propelled both by optimistic interpretations of macroeconomic data which sees “green shoots” in virtually every square inch of soil and investor hopes that we have seen the worst of this economic storm. Also, analysts estimates for the first quarter earnings were so low that nearly two-thirds of S&P 500 companies were able to beat those estimates.
As stated in the beginning of the newsletter, corporate earnings are still extremely low. Investors should be very careful about buying in at these levels because a pull-back seems reasonable. The rally has been prolonged by the entry of some formerly bearish money managers into the equities. We have to wonder how much longer this rally can continue without irrefutable evidence that corporate earnings are truly on the mend.
We are of the opinion that the market is overbought in the short term, and even though the economy may have in fact “turned the corner”, a pull-back would be warranted. Our asset allocation model has gone from our most bullish allocation target in March and early April all the way down to our most bearish allocation stance this week. This is largely because sentiment has become so extremely bullish, so rapidly that we are concerned. As contrarians, we are skeptical whenever a clear consensus develops in the market, especially when there is relatively little in the fundamentals to back up such stance. Although the market has been firing on all cylinders over the past three months, we urge caution at this time. There are still two huge elephants in the room that prevent us from proclaiming that a consumer-driven recovery is underway: record foreclosures and an unemployment rate nearing 10%.