Market View - May 2010

So as the long sunny days of spring continue, will this year like last year favour the brave who stay invested in equities, or will 2010 conform to form, in which case maybe we should sell in May and not come back until St Ledger's Day?

With some global equity markets having doubled since their post Lehman lows and the S&P 500 up around 80% since its March 2009 low, investors could be forgiven for taking some, if not all of their profits off the table, especially when looking at some historical studies including one that suggests $10,000 invested in the Dow Jones Industrial Average exclusively between November 1st and April 30th from 1950 through to 2003 would have grown to $480,000 while adopting the opposite strategy and being invested in the DJIA only during May to October during those years would have yielded just $328.

Quite why that particular study did not extend beyond 2003 right up to date is not disclosed although we all know how disappointed those who chose to adopt the strategy last year would have been, but more of that later...

At the macro level, concerns abound with the Sovereign Debt crisis threatening to spiral out of control in Europe, following Standard & Poor's decision to reduce Greece's rating to junk bond status, together with downgrades for both Spain and Portugal. Some of us might argue it's a shame the rating agencies were not so vigilante when it came to evaluating all the junk Collateralized Debt Obligation (CDO) issues underwritten by the big investment banks during the sub prime mortgage era! Still, perhaps we can draw comfort from the fact that the IMF has bolstered its emergency fund (for bailing out the likes of Greece) from $50 Billion to $550 Billion largely one suspects through the printing presses of the Federal Reserve and other G20 central banks!

Talking of CDO's, markets were also spooked towards the end of April by the US Securities and Exchange Commission (SEC)'s decision to sue Goldman Sachs for alleged fraud with respect to one of its client offerings. The case could offer regulators in the US all the ammunition they need to finally reign in the financial weapons of mass destruction (as Warren Buffet aptly named them)! In the long run, long overdue actions such as for example reinstalling the Glass Steagall Act (which should never have been repealed in the first place), and possibly outlawing all proprietary derivative trading and naked shorting of stocks (Lehman Brothers would not have collapsed were this scenario to have been law two years ago) would be a welcome return to sanity in financial markets.

In the short term however, such legislation would result in a massive de-rating of banks and financial sector stocks, since such a large percentage of their profits have over the past couple of decades come from these activities. Last but not least is the threat of a hung parliament here in the UK, since stock markets tend to dislike uncertainty

Coming back to our original question at the start of this commentary, an analysis using an alternative price earnings (PE) ratio measurement, namely PE10 which appears on the "dshort website" and was originally developed by legendary value investor Benjamin Franklin and is today championed by Yale professor Robert Shiller (author of Irrational Exuberance). PE10 divides the price of the S&P 500 composite index with the ten year average of the component stocks' earnings.

This approach helps overcome the shortcomings of the traditional PE approach which at times struggles to accurately reflect true valuations due to time lag in earnings catching up with price growth, a classic example being the fourth quarter of 2008 when earnings went negative for the first time in the history of the S&P 500 US benchmark. An advantage of the PE10 is that it much more accurately charts the real inflation adjusted price of the S&P 500 and has an historic average of 16.3 from 1871 to the end of the first quarter 2010.

Over a 140 year time frame, we have of course experienced two phenomenal bull markets, namely the roaring twenties when the PE10 ratio trough to peak went from 4.8 to 32.5. More recently the twin decade vintage that began in 1982 and peaked with the 2000 dotcom bubble, saw the PE10 ratio go from a low of 6.6 to a high of 44.2 (the all time record)!

While the PE10 went comfortably below its long term average when the S&P bottomed at 667 in March of last year with a ratio of 13.4, the ratio is now at 21.8 and back in the top quintile of historic monthly valuations. This would suggest the US equity market is currently at the very least quite expensive.

However those of us of a sunnier disposition can draw comfort from a more positive recent study that suggests the year long rally is set to continue for some time yet! A proprietary indicator developed by US specialist Ned Davis Research has a 100% accuracy record when back tested over the period between 1967 and March 2009, and during this time it has generated 12 buy signals for the S&P 500, with the average return over the following six months being no less than 13.1% with the lowest being 4.9% and the highest 24.3%.

Additionally a recent Bloomberg news report revealed that Earnings estimates for the S&P 500 constituents climbed more than 9% on average in April, effectively twice the move in prices and the largest monthly gain for several years. Currently the S&P 500 benchmark is trading at a forecast 14.2 times its companies' profits, which is lower than at any time since 1990 with the exception of the six months immediately after the Lehman collapse.

Income has been beating analysts' estimates by 22% during the first quarter with the market's consensus forecasts suggesting that the S&P 500's constituents could earn $85.96 a share in the next twelve months. This compares very favourably with the index's record combined profits of $89.96 a share in the twelve months to September 2007 when the S&P 500 was about 20% higher than at the end of April 2010!

Regardless of whether you believe global equities are currently cheap or expensive, the investment alternatives do not look attractive with the bond markets reflecting the sovereign debt concerns and the cash market depressed by the likelihood that interest rates will remain low for some time to help facilitate the anaemic global recovery. While we remain cautiously bullish on the outlook for the global equity market, there can be no denying the stakes have been raised and it will pay to tread warily over the summer months with tactical asset allocation more important than ever!