The Enterprising Investor’s Guide 6-29-2009

The price-to-peak earnings multiple held steady last week at 10.3x. The heated rally that has pushed the stock market upwards almost without interruption since March appears to be cooling significantly. For the first time since March, the S&P 500 closed down two weeks in a row and volume has started to slump as well. The stock market is at a crossroads right now and realistically anything can happen. One, the market could fall into the doldrums that often accompany summer months with tepid activity and paltry volume. Two, with the historically rocky early autumn months approaching, we could see a sharp pull-back in stocks. Lastly, stocks could continue to “climb the wall of worry,” seemingly oblivious to the risks associated with trading in rarified air. As we see it, the most likely outcome is that stocks will be range bound for the next few months neither gaining nor losing a great deal.

If the summer season’s earnings performance continues to build on some of the successes seen in Q2 and macroeconomic data beats expectations, we should see a continued rally in equities. After a rally of almost 40% in the S&P 500 index, we remain cautious as valuations are not nearly as attractive as they were about four months ago. The rally has lifted expectations and any sense that continuing headwinds in the economy will hamper a rebound in corporate earnings will prompt a retreat in stocks. Ockham believes that equity investors will soon need to see a significant improvement in fundamentals in order to sustain this rally, and if reality falls short of relatively ebullient expectations, we expect to see a correction.

The percentage of NYSE stocks selling above their 30-week moving average is 80% this week. This measure of investor sentiment dropped by about 1% over the last week, which is the third straight week of fairly small declines. We get a sense of unease within the market about which of the above described scenarios will play out in the months ahead. Will we see the “V-shaped” recovery that has been priced in to the equity market or is there a “W-shaped” recovery in store, as Nouriel Roubini predicts. This would imply that another leg down is ahead before a sustainable recovery takes hold, justifying higher stock prices. Those analysts prognosticating a “W-shaped” recovery are wary of the commercial real estate market and the potential ramifications of massive amounts of variable rate mortgage resets set to occur in the second half of the year.

Predicting the short-term direction of the market is nearly impossible to do with any accuracy so rather we use metrics for valuation and sentiment in order to judge the best risk/reward strategy. Currently, sentiment is rather inflated and the stock market is not particularly undervalued; in fact an argument can be made that it is overbought at present. Based on those factors, it would seem to us to be a good time to be cautious about the stock market. The optimism that the worst is behind us has come and gone, and now investors must see tangible improvements in order for stock values to merit their gains.

The Enterprising Investor’s Guide 6-29-2009

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.

Ockham Research provides its research in a variety of forms and products including our company specific reports, portfolio analytics tools, newsletters, and blog posts. We also offer a white labeling research solution that can give any financial services firm their own research presence without the time and cost associated with building such a robust coverage universe of their own.

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