The Enterprising Investor’s Guide for 8-23-2010

The price-to-peak earnings multiple has cooled for the second straight week and now rests at just 12.0x.  We are at a juncture in the equity market where we can easily make an effective bullish or bearish case for the near term direction of stocks; however, we never want to attempt to time the market .  Instead, we want to look at the market with a longer term view and adjust our outlook as the data warrants.

As our regular readers are aware, a multiple of peak earnings of 12 is regarded as a pretty good indicator of overall market being favorably valued.  However, since the market has not come anywhere near those peak earnings levels in three years, we must moderate our expectations.  In essence, we think that the market is slightly undervalued, but it is still fraught with potential danger.  Among the potentially dangerous themes at play are: slowing global growth, continued deterioration in labor markets, and geopolitical tensions that threaten to bubble over in the Middle East.  We mention these points of concern not as a scare tactic, but rather to demonstrate the bulls’ case has lost tremendous steam despite strong corporate earnings performance.  We continue to believe that volatility will remain persistently high for the foreseeable future, and as a result we are advocating a slightly less than normal allocation to equities.

The percentage of NYSE stocks trading above their 30-week moving average remains pretty consistent with the previous week at 41%.  It can be difficult to find conviction in the equity markets when volumes are seasonably low during the summer months, and the last few months have traded within a relatively tight range.  With market action yielding few clues on investor sentiment, we look to other indicators.  Survey’s of independent investors such as AAII have swung to the bearish direction of late with a relatively wide spread between bears and bulls (42.5% to 30.1%).  ICI fund flow data seems to confirm this as money has been flowing out of equity funds and into bond funds and other alternatives to stock funds.

On the contrary, the one key bullish indicator right now appears to be corporate merger activity.  We have seen a number of deals announced in the last few weeks including last week’s Intel purchase of McAfee that we featured on our blog.  That deal has already been unanimously accepted by the boards of both companies, but also BHP Billiton’s offer for Potash, while rebuffed by Potash’s management, does show a willingness to make massive deals in this environment.  In our view, this aggressive stance by corporate managers is a bullish signal and seems to fly in the face of so many months of negative reports on insider trading activity.

These are very confusing times for investors, and there seems to be more conflicting data than at any point in recent memory.  For example, earnings continue to come in better than expected even though analysts have made raised their estimates considerably.  If earnings continue on this trajectory and keep exceeding analysts’ estimates it is difficult to see how stocks would not raise as a result.  With that said, economic growth expectations continue to ratchet downward and the view on Main Street is horrible as the housing market and particularly the labor market are persistently awful.  In such a case, we think it is wise for long term investors to remain somewhat cautious.  We are not advocating getting out of the market entirely, but rather just that investors allocate slightly more to cash than normal.

Read the original story at Ockham Research