The Enterprising Investor’s Guide for 5-24-2010

The price-to-peak earnings multiple dropped to 12.2x as of Friday’s close.  Equities are undergoing a correction, having fallen four out of the last six weeks and nearly 11% from their recent peak.  Those market observers arguing that the “flash crash” of March 6th was an aberration or glitch are now eating their words as stocks have declined below their nadir on that day.  Perhaps the panicked selling of March 6th was a signal to the market that all is not well.

We regard this correction as healthy as it has brought equities to more reasonable and justified valuations.  Fundamentals have improved greatly over the last year; trailing twelve month earnings are up an amazing 217% over this time last year (marking the third straight week where that metric has reached a new highest level in 20 years).  So, with corporate earnings clearly improving, it is rational to expect that stocks would move higher.  However, the forces of FUD (fear, uncertainty and doubt) have a much stronger pull than do fundamentals at this time.  What investors must decide is whether this correction is simply the market re-pricing risk assets to a more logical level, or the precursor of a double-dip recession.  Our belief is that investors should protect themselves by buying high-quality stocks and bonds since riskier (high beta) stocks and junk debt remain the most overvalued securities in our universe.  We expect the stock and bond markets to experience a flight to quality.  In such an environment, stable, solid stocks trading at a discount to their peers should excel.

The percentage of NYSE stocks selling above their 30-week moving average declined greatly to just 38% as of last week.  Our sentiment metric shows that for the first time in more than a year, the bears now have the upper hand.  There are a number of reasons why investors are skeptical of current market valuations; chief among them is the fear that the issues in Greece will inspire contagion throughout Europe and then potentially on a global scale.  We believe there is a possibility of a double-dip recession brought on by Europe’s sovereign debt issues and a slow down (and potential real estate bubble) in China.  However, the US is undeniably in a better economic position and may be the primary beneficiary of the aforementioned flight to quality.  We are already starting to see the effect in foreign exchange rates as the USD is at its strongest versus the EUR in more than four years.

With that said, we are not suggesting the near term future of the market will reflect this comparatively better economic landscape.  Both sentiment and valuations were too hot for far too long, which makes equity prices vulnerable to further declines.

As always, we prefer to look at the stock market through a longer term view and adjust our view as the data warrants.  Our readers are well aware that we did not contribute to the chorus of bullish predictions over the last few months, as the market was indiscriminately overbought and overvalued.  This was not a popular view point; however, the recent 11% decline in stocks does vindicate our caution.  Still, S&P 500 earnings (representative of US stocks) are steadily improving and a continued pull-back in stocks will present long-term investors with an excellent buying opportunity.

Speaking of long-term, look at the interaction of price and earnings on the S&P 500 over the last decade.  While the S&P 500 has declined nearly 23% in the past ten years, earnings per share on that index have grown by 26% on a trailing twelve month basis.  The last decade experienced two major recessions, and it was clearly one of the worst ten year periods in stock market history.  Such P/E multiple compression may be distressing for some, but looking forward it is not such a bad thing.  When looking back at other such rough stretches in the stock market, the ensuing decade is generally much more hospitable to investors.  Unless you believe that we are entering a “new market paradigm”, stocks have historically returned between six and seven percent adjusted for inflation, so we think it reasonable to expect some improvement on those numbers as reversion to the mean works for investors, rather than against them.

Read the original story at Ockham Research