The Enterprising Investor’s Guide 6-28-2010

The price-to-peak earnings multiple slipped to 12.1x as of last week’s close.  Equity market valuations appear at first glance to be attractive as we have historically regarded 12x peak earnings as a strategic entry point.  Furthermore, with the rebound in corporate earnings over the last year, the S&P 500 now trades at about 17x its reported earnings: matching this metric’s lowest level since January of 2009.  We expect earnings to continue to show improvement as companies report their second quarter results in the coming weeks, although comparisons have gotten tougher as analysts have ratcheted up their estimates.

With that being said, we are increasingly concerned about the possibility that US economic growth is stalling.  This fear was fueled by the much-worse-than-expected ERCI Weekly Leading Index reading of –6.9%.  This reading was far worse than most economists had anticipated and puts this measure almost halfway to the abysmal level reached at around the time of Lehman Brothers’ collapse.  When this leading economic indicator shifts well below zero it normally spells trouble for the economy, as almost every time it has fallen decidedly below zero, a recessionary environment has followed (one-time in 1988 being the exception to this rule).  We do want to be careful not to place too much weight on a single leading indicator, but we do think it wise to remain cautious as government stimulus spending wanes, labor markets are extremely weak and housing appears headed for a double-dip.  This does not necessarily mean the economy is returning to recession, but it does cast doubt on some of the more sanguine economic forecasts and claims that we are in a V-shaped recovery.

The percentage of NYSE stocks selling above their 30-week moving average has dropped to 39% after last week’s declines.  Clearly, investor sentiment is no longer firmly in bullish territory as it had been for the better part of the last year; instead, we have returned to a more normal distribution of bulls and bears.  Indeed, the AAII poll of individual investors shows sentiment levels at near parity with 34.5% of respondents bullish and 32.4% bearish.

We believe that this week’s June employment report could be a key driver of investor sentiment going forward.  Since the market began its rebound in March of 2009, equity prices have risen in

anticipation of a full-blown recovery.  Since that time corporate profits have rebounded and the housing market has somewhat stabilized giving credence to this recovery theory.  However, the labor market has remained extremely sluggish, and this is perhaps most important measure of the health of “Main Street America”.  Job growth is clearly a lagging indicator but it has yet to show any improvement whatsoever—particularly in the critical private-sector.  Expectations for June’s jobs report are modest with the private-sector expected to add 113,000 jobs.   If reality exceeds these predictions, the bulls will rejoice from the falling unemployment rate.  However, if we get yet another disappointing report, we will see equity markets under pressure for a while longer.

The stock market seems to be having a crisis of confidence as the V-shaped recovery thesis seems to be challenged with each passing week.  As we occasionally do, we will turn to Dr. John Hussman as he has a way of taking historical evidence and making it useful today.  In this case, he references the recent studies by economists Kenneth Rogoff and Carmen Reinhart published in their book This Time Is Different.  Hussman challenges the notion that the systemic failures observed during the credit crisis have had enough time to work through the system.

“Reinhart and Rogoff observe that the outcomes of systemic credit crises have shown an astonishing similarity both across different countries and across different centuries. These lessons are not available to investors who restrict their attention to the past three or four decades of U.S. data.

Reinhart and Rogoff observe that following systemic banking crises, the duration of housing price declines has averaged roughly six years, while the downturn in equity prices has averaged about 3.4 years. On average, unemployment rises for almost 5 years. If we mark the beginning of this crisis in early 2008 with the collapse of Bear Stearns, it seems rather hopeful to view the March 2009 market low as a durable “V” bottom for the stock market, and to expect a sustained economic expansion to happily pick up where last year’s massive dose of “stimulus” spending now trails off. The average

adjustment periods following major credit strains would place a stock market low closer to mid-2011, a peak in unemployment near the end of 2012 and a trough in housing perhaps by 2014. Given currently elevated equity valuations, widening credit spreads, deteriorating market internals, and the rapidly increasing risk of fresh economic weakness, there is little in the current data to rule out these extended time frames.”  — Hussman’s Weekly Market Commentary 6/28/2010

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