The Enterprising Investor’s Guide 7-27-2010

The price-to-peak earnings multiple has expanded to 12.4x as of the start of trading this week.  We continue to see overall market valuation as reasonably attractive in an environment where earnings are clearly headed higher.  Market returns last week were mostly positive as earnings reports have continued to exceed analysts’ expectations in excess of 70% of the time.  This has been the case for the last few quarters as well, but the bar has certainly been raised yet lean companies continue to push ahead seemingly with little trouble.  Obviously, as fundamental analysts we see the trend of higher corporate earnings as a bullish sign for the stock market.

Many corporate executives have sounded cautious in conference calls with analysts as they see macroeconomic leading indicators slowing.  This is prudent as the future is still very uncertain with unemployment, housing and the consumer still struggling.  However, the shrunken cost structures throughout corporate America have allowed companies to benefit greatly from even a small boost to revenue.  Unfortunately for Main Street, we do not foresee most companies feeling confident about hiring in the near future, but as far as the market is concerned that is a secondary concern to profitability.

The percentage of NYSE stocks trading above their 30-week moving average stayed relatively flat at 35%.  So far this summer, investor sentiment has fallen much lower than a year ago, which in our view is a good thing.  We saw investor sentiment stay at exceptionally high levels for more than a year, and this brings the market back into a better balance between bulls and bears.  We no longer consider the market overbought from a long term perspective.

By now, every investor has been made aware of what has been happening in Europe as sovereign debt has crippled that continent and required stress testing of their banking system.  The good news is that the stress tests showed that the vast majority of banks would be able to survive even if conditions were to worsen.  The bad news is that the problems that brought Europe to this point are not unique and in the US we are starting to see more state, local, and federal government budgets pushed to the brink.  We believe austerity will be an increasingly important theme for investors to watch going forward.  We think a piece put out this week by First Trust Advisors this week summarized some of the key points rather well.

There are three types of austerity. Good, bad, and ugly.   Good austerity is the kind that puts the pain on the government sector. Bad austerity is the kind that tries to spread the pain across the public and private sectors. Ugly austerity is the kind that tries to put all the pain on the private sector.

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Keynesians (like Paul Krugman) argue that spending cuts hurt the economy. But nothing could be further from the truth. The benefit of spending cuts is that they can set off a virtuous cycle, reducing expectations of future taxes while invigorating the incentive to participate in the private sector. Every dollar less in government spending, whether financed by taxation or borrowing, means a dollar more in private sector spending. This is unambiguously positive for the macro-economy. Of course, those who have counted on government for business or transfer payments do not see it this way.

But voters and taxpayers, who were not around when promises were made, don’t feel beholden to support them. This is why political pressure to hold the Bush tax cuts in place is so plainly visible. The age of austerity for government has arrived. The only question is what form that austerity will take. –The Good, Bad and Ugly of Austerity 7/26/2010

Read the original story at Ockham Research