The price-to-peak earnings multiple advanced to 12.9x with Friday’s close as the market extended its recent winning streak; the S&P 500 now stands at its highest level since the September 2008 collapse of Lehman Brothers.  The major indices have been range-bound of late although all are trending higher because of increased merger and acquisition activity.  Over the last week,  major deals have been announced in the oil and gas, basic materials, and insurance sectors.  It should be noted that mergers are generally a bullish sign for stocks since it indicates that corporate management believes that good value exists in the equity markets.

As far as overall market valuation goes, earnings are steadily improving from last year,  which should not surprise anyone.  At its lowest point last year, trailing twelve month reported earnings for the S&P 500 had fallen 83%, mostly because of unprecedentedly huge asset write-downs.  Thankfully, earnings have rebounded substantially over the last year as write-downs have tapered off.   The S&P’s simple price-earnings multiple for the last twelve months stands at 23.3x, which is pretty high.  It is worth noting that S&P 500 earnings remain 44% below their peak levels of August 2007.  Thus, the market appears reasonably valued given current earnings levels and the potential for future growth, but it is no longer cheap unless one believes that earnings still have substantial improvement ahead.

The percentage of NYSE stocks selling above their 30-week moving average increased slightly last week to 79%.  Investor sentiment remains tremendously bullish as investor moods were buoyed last week with better-than-forecast retail sales numbers.  Macroeconomic data is benefiting from extremely easy comparisons from this time last year, but most economic data is improving modestly with the notable exception of employment.  We believe that employment and housing will continue to be a major worry for investors.

As we noted in the blog last week, labor statistics remain extremely weak.  However, suddenly,  many Wall Street strategists have labeled March the month that will provide an inflection point (The March Jobs Report Better Be Fantastic).  Monthly payroll

declines have moderated over the last year, and some analysts are predicting March job gains in the 250,000 to 450,000 range!  Part of this glowing outlook is attributable to the temporary hiring of government census workers.   Other than that, there seems to be little to back-up predictions of looming, sustained long-term employment gains.  To be sure, we hope that these forecasts are correct but with this optimism about the March report rapidly becoming “conventional wisdom”, any disappointment could hit investor sentiment hard.

We continue to believe that the market is in a precarious place right now and Mohammed El-Erian described the tug-of-war as a cyclical mentality versus a structural mentality.  The market’s cyclical mentality focuses on the fact that corporate earnings are recovering after a major recession, and equities appear to be one of the most attractive asset classes in a low interest rate environment.  On the other hand, there are major structural concerns which are more long-term in nature.  El-Erian believes that investors should become accustomed to a “new normal” which will define the next few years at least; included in this is a more budget-conscious consumer due to prolonged unemployment, increased government taxation, and slower growth ahead for the US economy in comparison to that of the emerging world.

In a way, the struggle that El-Erian describes is not a new concept as Ben Graham wrote about this dynamic back in the 1934.  To paraphrase one of his best known sayings, in the short run the market acts as a voting machine but in the long run it acts as a weighing machine.  El-Erian has said on many occasions that the market may have advanced further than is reasonable already, and yet, he would not bet against the market going higher in the short-term.  In this case, we agree.

The price-to-peak earnings multiple advanced to 12.8x as of last week’s close thanks to a 3.1% surge in the S&P 500.  We are now a year removed from the market’s nadir and in that time the S&P 500 has gained nearly 70%.  However, the S&P 500 still trails its all-time-high from October 2007 by 27%; this serves as a painful reminder of just how massive the bear market losses were.  In hindsight, it is clear that the market was overvalued in the fall of 2007, and was undervalued in the spring of 2009.  Predicting the short-term movements of the market is a fool’s game, which is why we try to focus more on  long-term trends while constantly assessing relative measures of valuation and sentiment.

As such, we thought it would be a good time to see what our EIG newsletter said at these market inflection points.  Remember in October of 2007, the subprime mortgage crisis was just beginning to unfold and financial firms like Merrill Lynch were just starting to report multi-billion dollar losses.  On October 12, 2007 we wrote, “We think that increased exposure to the stock market in this market climate can only be termed speculation. Our readers should be wary of taking any unnecessary risk in this clearly overvalued market.”

A year ago financial markets appeared on the edge of collapse as the solvency of major lenders  was in doubt because of continued losses and write-offs.  Real estate values were spiraling downward, joblessness continued to spread and pundits became an echo-chamber of the “this time it’s different” line of thinking.  On March 9th, 2009 the EIG said, “By all historical measures, we continue to believe that the overall market valuation looks attractive as [price-to-peak earnings] is lower than at any period since the EIG was established in 1989… Stocks are down close to 60% from previous highs and there is inherently much less risk in the market at these prices.”

We recall these inflection points not to say, “we told you so,” but to demonstrate that looking at the stock market through the prism of history provides more context than watching short-term market fluctuations.  At present, valuation is not extremely concerning, although we believe that sentiment is still the more obvious market driver .

The percentage of NYSE stocks selling above their 30-week moving average grew to 78% as of Friday.  This investor sentiment indicator returned to a fairly bullish position with last week’s close.  In the past week, the market rallied strongly thanks to growing M&A activity as well as stronger than expected consumer spending (February retail sales and January consumer credit) reports.  The rally resulted in the stocks of 743 members of the NYSE trading at new yearly highs compared to just 6 reaching new lows.

The market is nearing what we consider an overbought condition and we expect some normalization after a year of unending bullishness.  We continue to expect a moderation in sentiment over the coming weeks, especially if the government begins to reduce its assistance to the financial markets.  We view that the market’s biggest test for the balance of the year is whether or not it can stand on its own following a period of substantial monetary and fiscal intervention.

While valuation has risen steadily over the last year, corporate earnings have continued to improve as well.  Overall, the market is nowhere near as attractively valued as it was a year ago, but it is not particularly overvalued.  What we are more closely watching right now is sentiment, which can be extremely volatile but has consistently been bullish for the better part of the last year.  A contrarian investor should be at least cautious in this environment, as Dr. John Hussman reiterated in his weekly market comment:

“Despite the high level of bullishness here, the market has gained only a few percent beyond its September highs. Most of what we are seeing now is a tendency to make marginal new highs, back off slightly, and then recover that ground enough to register another marginal new high. As I’ve noted frequently, when market conditions are characterized by unfavorable valuations, overbought conditions, overbullish sentiment, and upward yield pressures, the market’s tendency is exactly that - to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere. Being defensive in that situation can make each slight new high feel excruciating, even if the market is not making much net progress. I remember that my own patience with this process was tested in mid-2007, when I quoted Wallace Stevens - “Does ripe fruit never fall? Or do the boughs hang always heavy in that perfect sky?”

The price-to-peak earnings multiple held steady last week at 12.4x as major equity indexes were little changed.  As in the recent past, earnings have come in well ahead of expectations; although, they still have a long way to go before reaching optimistic, full-year estimates.  At present levels, valuation is not a major concern so long as earnings steadily improve; however, we believe that a substantial amount of earnings growth has been priced into stocks at current levels.

Trailing twelve month reported earnings for the S&P 500 stands at $41.12, which represents a quick rebound from its multi-cycle low of $9.96 at the end of October last year.  This earnings recovery comes from two sources; first, far fewer asset write-downs have been reported, and second, a solid rebound in corporate profits largely due to reduced expenses.  Week-by-week, fewer write-downs are being factored into the earnings picture and  we will be very interested in seeing just how much organic growth is manifest in this economy.

The percentage of NYSE stocks selling above their 30-week moving average slipped a bit to 66% as of last week’s close.  In the current market environment, sentiment seems to be more troubling than overall market valuation.  As is clearly demonstrated by our chart showing one common measure of sentiment, over the past year or more we have seen extreme levels of both bearish and bullish sentiment.  Just in the last week we observed a number of decidedly bearish indicators (Latest Data Shows Sentiment is Firmly Bearish) related to various important sectors of the US economy.  In addition, sovereign debt in Europe continues to represent a huge uncertainty weighing on the market with Greece on the brink of default and, perhaps more importantly, Spain close behind.

Whether or not investor sentiment is simply moderating from extreme bullishness or may again swing to the downside is unclear.  We think moderation would be a healthy and natural development considering where we have been for the better part of the year.   In our opinion, sentiment rather than fundamentals has been the driving force behind the market’s recent bullish performance.  Thus, sentiment should be closely watched in the weeks ahead.

Last week, an upward revision of Q4 GDP to 5.9% barely moved the needle for the equity markets.  Of course, the stock market is forward-looking and thus investors will likely be more sensitive to this week’s data on ISM manufacturing and employment, especially with earnings season winding down.  For ISM, anything above 50 was considered an improvement, but economists on average expected something closer to 57.5.  The result, released Monday morning, was just shy of projections but did show relatively strong growth compared to the dismal manufacturing numbers from February 2009.  Improvement in the labor market has proven to be more elusive and we expect the unemployment rate to remain at 9.7% or possibly worse.

On the whole, we continue to advise long-term, value investors to be cautious about deploying additional resources into this market.  Overall market valuation is not particularly attractive and investor sentiment seems to us to be swinging to the bear’s side.  With that said, this is an optimal environment for owning high-quality, defensive stocks rather than the riskier securities that have been bid up in the last year as sentiment was riding high.

The price-to-peak earnings multiple advanced to 12.4x with last week’s bullish market performance.  Following a few shaky weeks, US equities have brushed off European debt fears and turned in their best two-week performance in more than three months.  Fourth quarter earnings results have given a big boost to the bulls during this time period.  With most of the quarterly reporting period behind us, nearly 70% of stocks have exceeded analysts’ earnings estimates.  Obviously, should corporate profits continue to improve, it will make it easier for companies to meet or exceed their full year 2010 earnings forecasts.

However, despite all of this good news, we must provide some context regarding the current earnings picture.  Trailing twelve month reported earnings for the S&P 500 is still less than half of its peak 2007 level.  Back then, earnings topped out at $89.22 per share and the S&P 500 was trading around 1500 with a P/E ratio of less than 17x.  As of last week’s close, the trailing twelve month reported earnings for the S&P 500 was $39.54 per share, with a price-to-earnings multiple of 28x.  Also, of note, the vast majority of credit crisis write-downs are now more than a year old, so they are no longer weighing down earnings.  In the future, favorable year-over-year comparisons are going to get much tougher.

This is not to say that the stock market was cheap in 2007, but rather that—based on reported earnings—US equities are actually pretty expensive right now and investors have priced-in a lot of future earnings growth.  With recent analysts’ estimates for 2010 S&P earnings coming in at between $75-$80 per share, it is clear that a substantial amount of further improvement is expected.  We believe that this sort of growth is possible, but even should it be attained, that equates to a multiple of 15x.  Any disappointment  in these earnings forecasts could be met with a rapid and sharp downward movement in stock prices.

The percentage of NYSE stocks trading above their 30-week moving average has increased to 69% as of the close on Friday.  Investor sentiment has rebounded quite strongly as it seems most market participants saw the recent dip as an opportunity to buy.  Furthermore, many global investors see the US market as a relative safe-haven when compared to the risks associated with other

developed economies, particularly the highly leveraged PIGS (Portugal, Ireland, Greece, and Spain) economies that threaten the stability of the Europe Union.  The most pressing concern in Europe is in Greece, which has 20 billion Euros of debt coming due in the next two months.  Without outside help, Greece cannot refinance this maturing debt and will default.  However as John Mauldin’s weekly insight illustrates, Greece’s issues maybe small in comparison to the problems facing Spain.  If an economy the size of Spain’s were it to need a bailout, the Euro would likely be doomed.

Even though Moody’s has warned that US debt may face a downgrade from AAA-status at some point in the future, for now, investors seem confident that the US is in better shape that Europe.  However, few economists deny that budget tightening, tax hikes and tough choices await US policy-makers as well.

At this point, it appears that the correction felt in the equity markets in January has abated, as earnings surprises and merger and acquisition activity boosted stocks.  However, we remain concerned that equity prices have gotten ahead of themselves and that a true correction could come at any time.  We would not be surprised to see the markets trade within a tighter range than we have become accustomed to over the last year, as expectations for growth mesh with actual results.

Furthermore, we were surprised and pleased to see the Fed raise the Discount Rate by 25 basis points last week.  This first of many tightening steps we expect to see over the coming year which signal a return to some sense of normalcy and is a show of confidence in the overall economy from the Federal Reserve.  The market will be anxiously watching for clues of Bernanke’s plans on Wednesday as he testifies before Congress in his regular semi-annual monetary policy meeting.

The price-to-peak earnings multiple rose to 12.1x as of last week’s close.  U.S. equities reversed four weeks of declines in last week’s trading as earnings continue to come in better than Wall Street’s expectations.  European sovereign debt issues, which have weighed heavily on the minds of investors, abated somewhat last week as the European Union announced a willingness to rescue Greece from default.  Although this should avert immediate disaster in Greece, more debt problems loom in Portugal, Ireland, and Spain.  Without significant fundamental economic improvement and a willingness to dramatically curtail debt-financed spending, the other PIGS (Portugal, Ireland, Greece and Spain) countries will come “hat in hand” for loan guarantees and bailouts soon; how can the stronger EU nations not rescue them after doing so for Greece?

Like all too many modern societies, the PIGS economies are excessively leveraged.  However, unlike most sovereign nations, since they are all part of a common European currency, they lack the ability to devalue their currency verses others, which is a common mechanism to deleverage in such a dire circumstance.  Individual countries within the EU have no access to fiscal policy tools that nations in such a dire situation typically use to combat such problems.  For example, historically, nations that reach this desperate situation normally lower interest rates and devalue their currency in an effort to export their way to growth.  However, using a common currency, these nations can only lobby for looser monetary policies.  The relatively-healthier and more influential economies of the EU (Germany for example) oppose such actions and actually are pushing for tighter fiscal policies.  This intractable conflict calls into question the sustainability of the Euro concept, whereby economies with very different fiscal needs are bound by a single currency.  It worked relatively well during robust economic times, but the challenges that lie ahead may prove its undoing.

The percentage of NYSE stocks selling above their 30-week moving average has rebounded to about 59%.  This level of sentiment is neither a bullish nor bearish indicator.  Based on recent market action, it is clear that investors are concerned about the rate of recovery.  We continue to believe that U.S. equities have priced-in a robust recovery despite the ongoing deleveraging cycle and continued weakness in labor and real estate markets.  No one…

knows how strong this recovery will prove to be, but we remain concerned about the risk to stock valuations of a slower-than-expected rebound.

Currently, the greatest economic uncertainties come from abroad rather than the U.S., which is a reversal from the initial stages of the Great Recession.  The Euro has a tough road ahead, and new reports out of China suggest that its recent exuberant growth is unsustainable.  The Chinese central bank is raising reserve requirements in an attempt to restrain growth following 10% GDP growth in the last quarter.  The Chinese recovery began before the rest of the world, and any weakness in China could presage a slow down in other parts of the world.  Over the last three months, Chinese stocks have fallen more than 10%.

Following the market’s recent correction and in combination with improving corporate earnings, we no longer see the U.S. equity market as overvalued.  Furthermore, sentiment has recently cooled to a much more moderate level, which was needed since it remained quite bullish for the better part of a year.  Now, the more pressing concerns for investors are overseas.  While Greece has been offered a lifeline, it is unclear what demands will be made of the Greeks regarding fiscal austerity and how that issue will play out in the months ahead.  In this week’s Thoughts from the Frontline Weekly Newsletter John Mauldin talks about the unenviable position in which the Greek’s now find themselves.

Between Dire and Disastrous

While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of “austerity measures,” otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years.

For my American readers, let’s put that into perspective. That is the equivalent of a $560-billion-dollar US budget cut this year and another such cut next year. That would mean huge cuts in entitlements, Social Security, defense, education, wages, subsidies, and on and on. And repealing the Bush tax cuts? That would just be for starters.  No “let’s freeze the budget” and try and grow our way out of it, as we effectively did in the ’90s, or gradually cutting the budget a few hundred billion a year while raising taxes. That combination of tax increases and budget cuts would guarantee a US recession. Unemployment, already high, would climb higher.

And yet, that is what the Greek government is being asked to do as the price for a bailout. — John Mauldin 2/12/2010