Stocks began March by plunging to fresh twelve year lows, but
the market finally found its footing, turned around and technically
posted its quickest new "bull market" -- as
defined by a 20% gain -- in decades. In the end, the S&P
500's 8.8% return in March was its best monthly return
since 2002 and its third best month in the last 15 years.
Is this really a new bull market? Is the coast finally clear?
While we retain our optimistic long-term outlook, and feel that
the current environment tends to be a better time to buy than
to sell, we are not convinced that new lows are completely out
of the picture.
For one thing, daily price volatility remains extremely high.
High volatility usually means investor anxiety remains elevated
and short-term market action could be choppy. Investor cash levels
are also extremely high with investors still more willing to
increase cash positions than equity positions. Also, we are about
to begin the first quarter earnings season -- and it is
expected to be pretty ugly. These factors, among many others,
could pressure prices lower. In other words, the big bear market
may not be over yet.
When can we be sure that the market will ultimately recover?
The answer, of course, is that we never really know when the
bottom has been established until well after the fact. There
are signs to look for, however, that may give us some clues.
In this report, I will look at five areas which we believe will
offer some of the first clues of a recovery and address some
of the factors we are monitoring in each area.
Area 1: Market Action
Broad Stock Market
Given that markets are fundamentally discounting mechanisms,
they often lead the economy. In other words, stock prices will
likely be higher, perhaps even significantly so, before we see
similarly improved economic data. So in that respect, it makes
sense to look at the market itself for the first clues that a
recovery is underway.
While it seems fairly self-evident that we need to see higher
stock prices for the market to establish a low that will stick,
it goes a bit deeper than that. We are not just looking at the
most recent direction of returns, but more importantly at the
behavior of returns over time to spot a potential change in investor
mood and action.
Looking at the chart of the S&P 500 above, we see that the
current low in this cycle is 676, registered on March 9th. Going
forward, we would like to see two things. First, during the next
pullback, we do not set new lows (i.e., any decline stops above
676). Second, in the next round of market strength, we would
like to see prices close above the last notable high price of
934 (January 6th, 2009). Basically, we need the market to start
hitting higher highs and higher lows instead of the reverse as
we've been witnessing since late 2007.
Key Market Sectors
Beyond the behavior of the broad market, we will be watching
the price action in the two sectors that led the market and
economy into our current mess: financials and housing.
As with
the S&P, despite impressive recent strength, we would
really like to see a move to new highs on the year. At
a minimum we
will be satisfied if these two areas do not break to new
lows.
Commodities
The commodity markets can also provide clues. First, higher commodity
prices often suggest better economic growth. Second, higher
commodity pricing could suggest percolating inflationary pressures.
While we typically would not be encouraged by the latter, given
current conditions, it would at least counteract some of our
concern about deflationary pressures currently in the system.
The market action seen in the commodities has been similar
so far this year to the prior markets we've reviewed. Thus,
what we're looking for is similar to what we would like
to see in the other markets -- that prices can stay above
the prior lows and start to move above the prior highs.
Within the overall commodity market, key individual commodity
markets to monitor include copper ("the market with a PhD
in Economics"), gold and energy. Each may provide unique information
on the economy and the markets.
Area 2: Sentiment
What Investors are Saying
Last month, investors reached their most bearish sentiment levels
yet in the current bear market, as the percentage of investors
calling themselves bearish in the weekly survey by AAII reached
an all-time high of 70%.
While these extreme readings are often a signal that a situation
is ripe for market reversal, ideally one would like to see
extreme levels start to moderate - which they did last month.
What Investors are Doing
What investors say and what they do are usually the same, but
not always. In this case, investors have been bearish and to
confirm, they have indeed been raising cash and dropping equity
exposure. Below is a chart showing that cash levels are extraordinarily
high. There are several ways this data has been presented,
but all of them say the same thing -- investors are extremely
defensive.
This chart above is really fascinating. First, it truly captures
how negative investors were in late 2008 - and still are. It
also shows the tremendous buying power on the sidelines. What
we would like to see is that cash being put back to work in
the markets.
Area 3: The Economy
Earnings
The earnings environment over the last few quarters has been
nothing short of historic -- historically awful. Despite
over 40% of the companies in the S&P 500 generating positive
sales growth last year, and over 80% of the companies turning
a profit, the net S&P earnings number for the fourth quarter
of last year was actually negative.
This was primarily the result of a few firms that reported gigantic
losses. Eighteen companies reported multi-billion dollar losses,
with AIG alone accounting for approximately a third of the over-all
earnings loss in the S&P. This has weighed heavily on the
market. In short, we need to see improvement.
It is hard to imagine we won't see improvement in the
year ahead. The comparisons should be -- one would think -- very
easy to beat. To prove that point, despite massive negative guidance
lower for 2009, the consensus expectation is that operating earnings
growth in 2009 will be nearly 30% better than 2008 and that reported
earnings growth will more than double! With growth rates like
that, the market is likely to approve.
It is also important to note that earnings projections tend
to be too negative near economic troughs (and too optimistic
near peaks). If we are indeed near a bottom in the economy, it's
likely that earnings will actually come in better than currently
expected, not worse. First things first though -- we need
to start seeing some of those companies at least hitting their
expectations. While earnings for the first quarter should remain
very weak, the key to watch for is how many companies at least
match expectations.
Housing
It is said that the housing bubble got us into this mess and
that it will have to lead us out. While the cause of the current
recession and bear market could be debated, and will be in
the years ahead, it's hard to debate against the positive
importance of a stabilized housing market. We need to see housing
prices stop falling.
Currently, the bleeding has not stopped. Prices are still falling,
and until they find a temporary bottom, it's difficult
to imagine a decisive end to the recession. This noted, we do
see some positives that suggest the bottom is near. Obviously
affordability is attractive. Inventories are down. Sales are
starting to improve. All we need now is for prices to improve.
If prices improve, consumer net worth improves, and then consumer
confidence improves.
Consumer Confidence
Consumer confidence is similar to investor sentiment in the way
it moves and how it correlates to the economy and the stock
market. Usually when people feel comfortable consuming, they
are comfortable investing as well. In short, as with investor
sentiment, when consumer confidence is low, but beginning to
rise, it is typically a very powerful and positive signal for
the economy and markets.
At present, it's hard to convincingly say that we've
seen the lowest levels we'll see in consumer confidence,
though it would be reasonable to think that the bottom is near.
Now, we just need to see some improvement.
Shipping
Another early warning signal is shipping; if production/sales
are increasing those goods have to be shipped to markets/customers.
One could look at overseas shipping, and trucking, or railway
traffic here in the U.S. It seems to be a mixed read right
now, though it does appear that the economy may have witnessed
its
worst late last year.
Let's look at railway shipping.
Railroad traffic is clearly
down quite a bit from last year. Yet, shipping appears to have
bottomed months ago. Again, as with the other data series we're
watching, we would like to see lows moving upwards and data
improvement from current levels.
Area 4: Government Policy
Government policy has played a very large role in market direction
in recent months. Regretfully, most of it has been negative.
While it can be argued the stimulus packages are too big, or
not big enough, the bigger problem early on was that there
weren't enough details. The various programs needed to
be introduced and explained so that people could assess and
act. While all the details are still not out, there are now
hopefully enough pieces of the puzzle on the table. Some of
these include:
- Market Liquidity Programs
-
The Treasury, Federal Reserve and FDIC all have plans which have
attempted to maintain a properly working market place -- many
officials have looked to instill confidence (both consumer and
corporate) in the market place.
- Asset Repurchase Programs
-
TARP, TALF and PPIP plans are targeted as removing assets from bank balance
sheets to which the market is not providing liquidity at this time.
- Bank recapitalization programs
-
Many large banks have received billions in capital injections -- government
has effectively taken a stake in many of the nation's largest banks.
- Accounting Rules
-
FASB to revisit up-tick and market-to-market rules this spring -- markets
would likely have a positive reaction to any form of rescinding of these rules.
Area 5: Valuations
Valuations are not necessarily a short-term signal we're
focusing on, because quite frankly, while valuations appear to
have a modest ability to predict returns over a one-year time
frame, they are more effective at suggesting what 5- and 10-year
returns might look like. In short, they look positive.
Price/Earnings Ratio (P/E)
First, let's look at a five-year normalized price/earnings
ratio. We like to use a 5-year period as it helps smooth out
the impact of the business cycle and provides a smoother signal.
This is especially the case given the negative earnings in the
fourth quarter. In short, valuations are the lowest they have
been since the early 1980s and approximately 40% below their
50-year average.
Dividend Yields
Next, we can look at dividend yields. In an absolute sense, dividend
yields are the highest they have been in nearly 20 years. What
makes yields even more attractive is that this is the first
time they have been higher than Treasury yields since the 1950s.
Summary
What the market accomplished in the last half of March was
impressive. More than anything, it provided some relief from
the constant
pounding of market losses earlier in the year. Nonetheless,
the market is still down for 2009, and we should assume that
none
of us are out of the woods yet. Still, there are some encouraging
signs that the worst is finally behind us.
For the longer-term investor, however, whether we hit new lows
or not, the current environment remains very attractive for maintaining,
or adding to, current equity positions. Is the current environment
the buying opportunity of a lifetime? Those are sensational words,
but given the startling losses of the last year plus, it is not
unreasonable to expect that the markets could generate very attractive
returns in the years ahead.
Sincerely,
