The Enterprising Investor’s Guide for 8-30-2010

The price-to-peak earnings multiple has slipped to just 11.9x as of Friday’s close matching the lowest it has been since October of 2009.  US equity markets fell for the third straight week and have now dropped in seven out of the past ten weeks.  With the poor overall performance this summer, investors can be thankful that most of the volatility has been confined to a fairly narrow range.

Fundamentally, this was the sort of break we thought that the markets needed in order to cool the overbought condition we saw this spring.  At that point, stocks had rallied non-stop for more than a year without so much as a 10% correction.  Meanwhile, as some of the air has been let out of stock prices, we continue to see corporate earnings results continue to mostly exceed expectations.  In such a case, we do see some glimmers of hope in the equity markets.  On a trailing twelve month EPS basis, the S&P 500 is trading for a multiple of about 16.4x and not particularly attractive.  However, if we assume that earnings growth can keep up with analysts’ expectations through the end of the year, the market is trading for just over 12x times earnings per share.  Of course, that is not the cheapest valuation we have seen and there is still plenty of uncertainty, yet we are finally starting to like the value proposition in the market.

The percentage of NYSE stocks trading above their 30-week moving average remains just about unchanged at 41% for the third straight week.  Again this week, we are not seeing a clear signal one way or the other in terms of our investor sentiment metric, but there are other metrics we can use to show that bearish sentiment is clearly on the rise.  For example, we have noted a marked rise in pessimism among individual investors and the AAII survey takers were 2.5 times more likely to be bearish than bullish looking forward (20.7% bulls versus 49.5% bears).  This has progressively gotten worse as fears of a double-dip remain prevalent in the financial media.

One other interesting thing to note, it seems that the Wall Street analyst community has uniformly turned bearish as well.  Collectively they seem to believe that earnings are going to continue to rise strongly and steadily; however, buy

recommendations are down tremendously.  Could this be another situation where the analyst’s community gets in “group-think” mode and convinces themselves that the double-dip is upon us?

For the first time since at least 1997, fewer than 29 percent of ratings for stocks covered by brokerages worldwide are “buys,” according to 159,919 recommendations compiled by Bloomberg. Analysts are turning more pessimistic even as they push up estimates for profit growth among Standard & Poor’s 500 Index companies to 36 percent, the highest since 1988…

More than 54 percent of ratings for companies in the U.S., U.K., Japan and Brazil are “holds,” the highest level since Bloomberg began tracking the data in 1997. While the proportion of “sell” ratings in the U.S. has fallen to 5.1 percent, half the level of 2003, the total combined with “holds” reached a record 71 percent last month, the data show…

“Everybody is a little nervous to go out on the edge,” said Stone, whose firm oversees $103 billion. “That’s a positive. It gives the opportunity to either buy stuff that should be somewhere else. Maybe it’s a good company that’s being dragged down by the overall market.”

Profits for companies in the S&P 500 are forecast to reach $83.34 a share in 2010 and climb 22 percent in the next 12 months to a record $92.15 a share. Even slowing economic growth wouldn’t mean a stock-market crash, according to Laszlo Birinyi of Birinyi Associates Inc., which cut its year-end estimate for the S&P 500 to 1,225 from 1,325 on Aug. 25.—Bloomberg.com 8/30/2010

For a long term investor, we believe that uncertainty over the future may create an opportunity to build positions in high quality stocks.  As the Bloomberg quote demonstrates, Wall Street analysts seem to be talking out of both sides of their mouths.  First, they think that earnings will continue to improve and will reach new record highs in 2011, yet a cloud of doubt surrounds the market such that they are not advising buying stocks right now.

In the end, we believe that these two circumstances will not be able to persist for very long because over the longer term stock prices are correlated to earnings growth.  Our advice would be to remain vigilant as a sell-off could potentially wipe away another 5% to 10%, but with earnings growth providing the foundation for the market stocks will eventually head higher.