Sentiment and Valuation: Little Not to Like in This Market

[click on images to enlarge]

Valuation analysis is most pertinent when the markets are behaving rationally, but as of right now the markets are being fueled by fear and uncertainty. All the same, one cannot ignore valuation because although they may be of minimal importance for the short term, these historically low valuations are extremely important to a long term investor. The price-to-peak earnings multiple has again fallen to a new low of 9.8 times. This is the lowest level the market has hit since we began tracking in 1989. 

The S&P 500 is continuing its decline as the market tries to find a floor. As soon as the market sees a slight uptick, hedge fund redemptions can and do beat stocks back down. We think that the stock market is nearing a bottom and that the recapitalizing of banks by the Fed should continue to ease the credit crisis. Once banks regain trust and consequently are willing to lend, we could see a sharp bounce back in the market even though there are real and persistent fears of a deep recession. 

Our sentiment indicator has also broken new ground in this bear market as the percentage of NYSE stocks selling above their 30-week moving average is just 3%.  We view this as a bullish signal because whenever a clear consensus is formed in investor sentiment, history has shown that it’s wise to be of the opposing view. Never have we seen this sentiment indicator so far to either extreme as we have seen in the last month. When you take the largely bearish sentiment combined with the extremely oversold conditions, value investors must at the very least be intrigued.  The long term investor must think: these conditions cannot persist indefinitely and cannot get much more extreme, so now truly is a justifiable time to invest. That does not mean that buying anything and everything is wise, but a diversified portfolio of carefully selected stocks will in all likelihood have a nice return over the next 12 to 18 months.

As you may have guessed from the previous two topics, our asset allocation model remains at our most bullish stance possible this week. When looking at the two key metrics of Sentiment and Valuation, there is little not to like about the currently oversold and overly bearish stock market. No one can predict when the bottom will come but what the market needs is a catalyst that will clear some of the uncertainty about the future. The massive and unprecedented government interventions into the economy have yet to be effective, but still have the potential to thaw the credit market and at least provide a minimum level of liquidity to the system until it gets back on its feet. Also, consider the presidential election, which is now just eight days away, and looms as a big question on many people’s minds. No matter who wins the election, it will solve one more piece of the puzzle and the market could rally for either candidate.

Comments

[Roger Knights:]

Typo in: "the percentage of NYSE stocks selling below their 30-week moving average is just 3%."

That "below" should be changed to "above." Compare to the caption of the accompanying chart, which uses the "greater than" symbol: >

2008 Oct 28 07:48 AM

[Smarty_Pants:]

"This is the lowest level [of P/E] the market has hit since we began tracking in 1989."

Note that 1989 was shortly after the beginning of the last great bull market. Not exactly a robust historical data set to be using for comparisons. Once earnings estimates have had a chance to revise downward to account for recessionary impacts that P/E multiple may be much higher than it is now (at current prices).

For a historical comparisons look at P/E's at the lows of the 30's bear market. You will find that a P/E of 5 or 6 was not uncommon, and that was after earnings had been squashed as a result of depressed levels of business activity.

These facts alone are enough "not to like" at the present time in my book. I think I'll wait until the dust settles before I jump back into an ongoing bear market.

2008 Oct 28 10:29 AM

[Larry House:]

Just look at the daily market action; you will see lots not to like. The market may bounce, but there is nothing on the radar that would signal a bottom first or a new upward TREND second. Cash is more to be liked than this market.

2008 Oct 28 11:26 AM

[ockham:]

Roger Knights: You are absolutely correct and I have changed it in our blog at blog.ockhamresearch.co... but I cannot do much about where it has been republished around the web. I apologize for any confusion. Thanks for catching that slip.

2008 Oct 28 11:49 AM

[ockham:]

Smarty_Pants: You point is also well received. You are correct that the statistic used when discussing the price to peak earnings multiple is only referencing about 20 years, which has been a relatively steady bull market, and thus may not give a full representation through bull and bear markets. Just to point out though, there have been extremes in this valuation metric during this time as price-to-peak got up to 34x during dotcom and low teens in the early 1990's...

However, I should have been more clear in stating that I was referencing only data since we began publishing our newsletters, which just happened to be the beginning of the extended bullish run. I was not trying to select a period that would distort the facts. I think it is relevant that price-to-peak has fallen so far, so fast. Almost certainly more relevant than comparing the current recession to the depression of the 30's.

Anyway, thanks for your comments because after all, that is what forum's like seekingalpha are for...comparing and discussing differing view points.

2008 Oct 28 12:32 PM