The price-to-peak earnings multiple has retreated slightly to 12.7x as of Friday’s close. On Friday, the market endured its first triple digit sell off despite fairly strong earnings reports from technology and financial bellwethers Intel (INTC) and JP Morgan (JPM). Both quarterly reports topped analysts’ expectations for profits but fell short on sales, which has renewed worries that earnings growth continues to be driven by cost cutting rather than true growth through higher sales. Earnings season has only just begun, but if this is a theme that continues throughout the reporting period we would expect there to be some correction in the equity market. There has been a significant amount of economic improvement priced into stocks right now, and if the recovery is slower than first thought a pullback would be reasonable and possibly unavoidable.
The U.S. market is closed on Monday in honor of Martin Luther King Day, and the rest of the week will be relatively light on economic data. So, the market will likely be driven by several key earnings reports. There is little doubt that the earnings reports will be much better than a year ago, but they may fall short of the lofty expectations that have been priced into the equity market at this point. In order to have significant upside, stocks will need to justify their appreciation with strong revenue growth often accompanied by an optimistic outlook.
The percentage of NYSE stocks selling above their 30-week moving average fell to just under 86% as of last week. This metric for investor sentiment remains quite bullish, and we view this as a clear warning sign for long term investors. Whenever the market shows overwhelmingly bullish or bearish tone, contrarian investors become distrustful of the conventional wisdom. To be sure, this is not a mechanism for timing the market but rather an overbought/oversold indicator that over the course of time is a defensible way of judge the market’s stance.
We are not calling for a double-dip recession, but we think that the possibility of that occurrence deserves respect. The market may continue to trudge higher, yet the risks of abrupt losses remains relatively high. Unemployment, foreclosure, consumer credit, excess housing supply and other factors are still looming in the background and should not be forgotten.
For long term investors, we think it is appropriate to remain in the stock market right now although at a more defensive posture than your normal allocation. This market is nowhere near bubble levels as some of the more extreme bearish analysts are saying, but we do think there is a fundamental disconnect between the market and the real economy (comprised of many cash strapped and worried households and small business still struggling to get access to credit, hire, and grow). As far as we can tell there are only two likely outcomes, the economy improves to the point that the market has called for and stocks churn marginally higher or stay within a tight range. Alternatively, the economy continues to show significant signs of weakness and stock market valuations cannot live up to the expectations of a standard post-recession recovery. We think that the risk outweighs the reward in this situation and investors should cycle out of the highest risk stocks and transition into more defensive, low risk stocks.
