August 23, 2010 – Market Commentary

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One would be led to think that the uptick in unemployment claims was a signal that earnings growth will dramatically slow.  That conclusion seems a bit hasty particularly in light of the fact that earnings in Q2 came in at 49% above Q2 2009 and were 15 percentage points above the consensus estimates for growth going into the earnings season.  Keep in mind that the median year over year change in the S&P 500 earnings since 1928 is only 8.6%.

ScreenHunter_07 Aug. 24 12.23The above chart comes courtesy of the Bespoke Investment Group on their blog at

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I have updated the work on the “p/e ratio” of 10 year Treasury bonds (i.e. divide 100 by the yield) that I presented in July in contrast to the p/e ratio of the S&P 500.  Since that time the 10 year rate has gone down and the earnings for the S&P 500 have gone up.  The 10 year Treasury is yielding 2.6%.  The earnings yield on the S&P 500 is 7.3% (using LTM operating earnings adjusted for Q3 estimates).  The spread between the 10 year rate and the earnings yield has expanded to the widest since December 1974.  The S&P 500 rose 21.6% in Q1 1975 following the sharp widening of the spread in the fall of 1974.  The S&P 500 was up 31.5% in the 12 months following the wide spread of Dec. 1974.  The spread today is even wider than in 1974 when one considers that the spread today is equal to182% of the 10 year Treasury rate vs. 74.5% of the 10 year rate in Dec. 1974.  The historical implication is the odds favor stocks rising in the near future.

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Treasuries are trading at an implied p/e ratio of 38.4X.  As I said in July, with stocks, earnings can improve and drive up the value of the shares.  With bonds – the amount of income is “fixed” – So if the “p/e ratio” of bonds is at an extreme high and income is fixed the only thing that can adjust if the “p/e ratio” should decline is price . . . and the “adjustment” would be down.

 It was noted by Bloomberg that bond funds attracted $559 billion of net inflows in the 30 months ended June.  Bloomberg went on to note that investors withdrew $209.4 billion from domestic equity funds in the same time frame.  This is as strong a contrary signal to sell bonds and buy stocks as you may see in a lifetime of investing. 

 In closing, I have chosen to present an update of my over/under valuation chart that plots the S&P 500 relative to implied value of the S&P 500 if it was capitalized by the 10 year treasury rate.  The S&P 500 has never been so undervalued as it is today.  The model implies that the S&P 500 is trading 64.5% below where it should be trading given today’s level of interest rates and operating earnings.

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Bottom Line:       

1) The recent economic data headlined by the unemployment claims data does not signal a reversal in the economic recovery that is evidenced by the surge in earnings. 

2) Bonds are selling at historical high prices and low yields and should be sold or hedged.

3) The S&P 500 has never been as undervalued in modern market history.

The Wildebeests are Wandering – A One Question Survey

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Aberdeen sent out a one question survey to over 250 friends and clients on July 30, 2010.  The recipients are sophisticated investors from all over the U.S.

 The survey asked the recipients to provide an indication where they stand in terms of U.S. market prospects.  38% of the recipients opened the survey and 17% of the recipients responded.

 The responses were as follows. 

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 Our crowd is clearly “cautiously optimistic”.  It’s an open question if this means “ready to re-enter the market” or “sit tight – hold cash”.

 There were quite a few comments.  49% of the respondents provided more color to their views.  The comments were most consistent in concerns about the size of government and prospect for rising taxes.

 The ratio of the bulls to the bears was 0.70.  The following chart from Yardeni Research provides some historical context to the low bull/bear ratio.  As you can see, “low” = “good time to be a buyer” and is consistent with recent low points in the market in 2002-2003 and 2008-2009.

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