Technicals, Sentiment and Valuations

The following is an excerpt from an article in today’s Wall Street Journal:

“One of the tarot cards in the technician’s deck is the 200-day moving average, a measure of the trend of a stock, index or tulip bulb. Being too far above or below that average can be a sign a correction or rebound is due. Currently the Dow is 32.6% below its moving average, not far from its 34% undershoot on Nov. 20, just before it rebounded. It is rare for the Dow to be more than 30% below the moving average. The only other instances were during the Depression, though there were less-deep troughs in 1974 and on Black Monday in 1987.”

This next excerpt was posted on’s “InPlay” web site on Tuesday:

“January fund data shows money market assets accumulating further and money managers hoarding more cash…at the end of November 2008, money market fund assets surpassed stock fund assets for the first time in at least 11 years. This situation came about as a result of equity market declines and high levels of risk aversion. There have been two months of data released since then, with January data (released last Thursday) demonstrating that high money market and cash levels remain. This latest month’s data showed that stock fund assets fell even further, below the November lows, after a slight increase in December. Total stock fund assets are now at their lowest point since September of 2003, as continued declines in equities erode the total value of holdings. Money market fund assets continued to grow, making new highs as investors continue to put money in the safest of assets. While the portion of funds in Money Market assets continues to grow, its pace of growth decelerated over the December and January periods, with January showing the smallest increase since September of 2008. This comes as treasury yields hang around historically low levels… Another indicator of continued risk aversion is the portion of stock fund assets that are in liquid assets or cash. Liquid assets in mutual funds as a percentage of total assets fell 20 bps in December to 5.2% but jumped 60 bps to new highs in January to 5.8%, the highest since March 2001, suggesting that money managers are hoarding cash while equity markets trade at the lowest levels seen since the late 90’s… Overall, the two most recent months of data don’t show any major changes to the trend that was highlighted in January — money managers are increasingly hoarding cash at higher levels, and money market assets continue attract funds (albeit at a slowing rate) while stock fund assets continue falling”

In our last email (Monday of this week), we speculated that negative sentiment seems to be reaching a crescendo and that nearly-unanimous pessimism is one of the necessary ingredients in the bottoming process. In Monday’s horrible decline this week, 14.6 stocks on the New York Stock Exchange were down for every one stock that traded up. Moreover, the volume of stock that traded down represented 51.1x the volume that traded up on that day. Using more anecdotal evidence, we are seeing a strong preference for bonds over stocks for new accounts coming in. We continue to believe that pessimism is running rampant in today’s market, but we also recognize that there are other necessary ingredients in forming a bottom. As long as we have severe dislocations in the credit markets and housing prices keep falling, we believe the market could be volatile. Considering stocks for investment today requires that we once again become “investors”, meaning we commit money with the intent to hold on to the investments for the long term (which we generally define as 3-5 years). Once we get comfortable with commiting to this “investing” time frame, we simply need to get comfortable with valuations.

Intense debate continues over whether today’s market levels represent good value for longer term investors. I thought I’d take a stab at explaining where we stand on the issue. First, it is true that price/earnings ratios normally go below 10x before we hit a period where we can “expect” above-average returns for the next 10-15 years. However, P/E ratios cannot be viewed in a vacuum. They have to be compared to potential returns on other investments. For instance, bond yields in the 1970’s were in the teens reflecting soaring levels of inflation. To a large extent, the low P/E’s of that era were necessary to attract investors given the high level of interest rates. Today, the P/E on 2009E S&P 500 EPS (operating EPS…I realize that actually earnings are lower but we don’t think it’s realistic to assume that giant bank write-downs will continue forever) is about 11.5x. This is an earnings/price yield of 8.7%. At the same time, the yield on the 10-year treasury is currently 3.0%. Subtracting the yield on the 10-year Treasury from the earnings yield for the market yields an equity risk premium of about 5%-6%.

Now, earnings may indeed go lower due to the negative operating leverage and thus the P/E may eventually look higher. However, we would argue that some form of “normalized” EPS should be used in our analysis since operating leverage will ultimately cause EPS to snap back quickly once sales stabilize. In any event, the point is that P/E ratios don’t look too bad relative to interest rates. Stock prices and P/E multiples could obviously go lower in the near term, but we appear to be at a level that suggests solid long-term returns from current levels. Consider the following: the dividend yield on the S&P 500 is 4.0%; the P/E on the S&P 500 is below the market’s 15x long-term average; and, we conservatively assume corporate profits will grow at 5% per year over the next 10 years beginning from a level that is 30-35% below peak earnings in 2006. This earnings growth assumption implies that S&P 500 earnings get back to roughly 2006 levels in 10 years. Add this all together and one gets a 9% return from equities (5% earnings growth plus 4% dividend yield) with no expansion in the P/E ratio. Most professional investors would be very happy with a 9% return, especially in this interest rate environment. As a caveat, we would say that if the world is going to end, stocks aren’t cheap. But predictions for the end of the world have thus far fallen a bit short.