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?”
