The Enterprising Investor’s Guide 6-21-2010

Last week, the price-to-peak earnings multiple advanced to 12.5x with stocks posting an almost five percent gain–the equity market’s best two week run since November of last year.  We continue to believe that the market’s overall valuation is favorable because of the recent correction and the fact that corporate earnings continue to be strong.  We remain cautiously optimistic regarding earnings going forward, largely because US companies are lean, mean and favorably positioned globally.  However, we are cautious because favorable year-over-year earnings comparisons will be much harder to exceed going forward.

It was interesting to see the market’s tepid reaction to further European sovereign debt downgrades, although stress tests showed Spanish banks were actually stronger than once thought while the banks most at risk were some of the smaller, privately-held German banks.  Accordingly, some of the largest Spanish banks such as Banco Santader (STD) and Banco Bilbao (BBVA) saw their stocks appreciate quite nicely last week.  With little in the way of earnings releases this week, investors will focus on macroeconomic data and events in the week ahead.

The percentage of NYSE stocks trading above their 30-week moving average rose to nearly 49% as of the close of trading on Friday.  Investor sentiment appears to be just about even keel as investors are attempting to appropriately assess the evolving risk/reward profile for this market.  The last two weeks have been at the very least encouraging, as there has been little in the way of positive data for the market to latch onto, and yet stocks have steady moved higher.  However, with sentiment neither overly bullish nor bearish, we do not read very much into week-to-week movements in this data point.

Futures are poised to extend recent gains after indications out of China that they will allow greater fluctuation in the yuan’s exchange rate, which has been tightly controlled for years.  The yuan has been pegged to the USD since July 2008, but now the Chinese central bank has stated they will allow a gradual strengthening in an effort to nip in the bud possible tensions as the G20 is scheduled to meet in Toronto next weekend.  Allowing the yuan to strengthen gradually has been interpreted as an indication of confidence in the global economic recovery and additionally, it tamps down inflation fears.

This is a significant sign of maturation for one of the world’s fastest growing economies, as this will promote a shift from the export-driven growth towards service industries which many experts see as a more sustainable path.  Hopefully, in time this will help the Chinese economy develop greater balance in foreign exchange and also initiate stronger domestic consumption as Chinese citizen’s buying power should grow.  This may turn out to be a double edged sword (and I am not just talking about fewer cheap goods out of China’s factories); as the yuan strengthens, it will necessarily tilt the trade balance toward balance, and that may mean less demand for US Treasuries from the Chinese government.  We would welcome recognition of this possibility by those our leaders in Washington exhibiting a willingness to drastically reign in spending; however, realistically, this looks like wishful thinking.

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