The Enterprising Investor’s Guide 6-7-2010

The price-to-peak earnings multiple fell to just 11.9x as of Friday’s close.  We are seeing overall market valuation return to a much more enticing level as we generally regard a peak earnings multiple of 12x to be a historically justifiable level for long-term buying.  At the same time, corporate earnings are clearly improving rapidly.  Trailing twelve month earnings per share on S&P 500 companies has risen by 170% over this time last year, and now earnings per share are only 30% lower than their all time peak.  We are seeing the market correct even as the underlying fundamentals improve.  This is a welcome sign for investors because, even though stocks may have further downside, in general, stock prices have reached levels where long-term investors can buy selectively on dips.

The percentage of NYSE stocks trading above their 30-week moving average has fallen to just 32% as of the end of trading last week.  This indicator of investor sentiment showed another decline last week and many stocks now trade below key technical levels.  With no major earnings releases impacting valuations, the cause of last week’s weakness was further sovereign debt worries in Europe as Hungary became the latest economy with significant problems.  Furthermore, oil slicks and tar balls are now hitting coastal communities in Mississippi and Alabama adding to the damage already done to coastal Louisiana and threatening vital seafood and tourism industries in the area.  These two situations are likely to loom large in the minds of investors in the coming months and headlines arising from them will only heighten volatility for some time, more than likely to the bearish side.

Last week, US stocks sold-off heavily on Friday following a tepid jobs report.  Private sector job growth was anemic and the vast majority of jobs created were due to temporary census work.  Bullish pundits have latched onto the silver lining that both hours worked and wages showed an uptick in the month as these are leading indicators for job growth, but there is no denying the overall report was much weaker than expected.

Despite all of the doom and gloom in the news these days, the combination of the market’s improved valuation and the drop in sentiment are a healthy occurrence in this situation.  We believe that long-term investors should remain cautious going forward, but should consider selectively buying over-sold stocks on down days.  Of note, we do not believe that BP (BP) is a buy right now, although in time it may prove to be.  However, the company’s ultimate liabilities are impossible to discern at present and we would avoid the stock for that reason.  Of note, other oil stocks that have nothing to do with the disaster have been savaged as a result of the BP oil spill and most should be fairly well insulated against possible legislative changes.  Royal Dutch Shell (RDS.A), which has fallen 17% in just over a month and now yields 6.4%, represents an attractive name for the enterprising investor.  The company is fundamentally strong, but it has struggled of late due to the oil leak and the ensuing drop in crude oil prices.   Income-oriented investors may want to consider adding RDS.A to their portfolio.

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