Monday, January 18, 2010

Sentiment, Earnings and Asset Allocation: Making Sense Of The Data

In an effort to understand the potential direction of the overall market, one of many factors I look at is the investor sentiment data. A number of other strategist review this same data. The reason for including this variable in ones criteria for determining the future direction of the market is individual investors tend to plow into stocks at the top of the market. Consequently, high bullish investor sentiment could signal a market that is near its top.

The individual sentiment data reported last week by the American Association of Individual Investors shows bullish investor sentiment rose over six percentage points to 47.4% from last week's bullish sentiment reading of 41%. This reading is below the average plus one standard deviation of the bullish sentiment reading. The 8-period moving average of the bullish sentiment reading increased to 43% from 42% last week. At the market top near the beginning of 2000, the 8-period average was in the high 50's and even hit 60 at one point. In short, sentiment is elevated, but does not seem to be at an "extreme" level yet.

What about investor asset allocations? Again, AAII allows investors to note their overall asset allocation on a monthly basis on the organization's website. The December allocation is reported at 64%/18%/18% (equity/bonds/cash). Going back to late 1997, the long term average allocation is 60%/15%/25%. Given the low interest rate environment, it seems reasonable that investors would have lower allocations to bonds and cash. Additionally, the magnitude of the equity market's advance last year will force down the weighting of the bonds and cash simply because of the market growth in equities. Again, going back to 1997, the maximum equity allocation reported by AAII is 77% and the lowest reported cash level is 11%. As with the sentiment data, I do not view asset allocations at "extreme" levels.

Finally, what do earnings for the S&P 500 Index look like for 2010? Standard & Poor's is reporting the estimate for bottom up operating earning on the S&P for 2010 is $76.37. This represents a nearly 37% increase over the final estimate for 2009 of $55.79. The 2010 projected P/E for the market is just under 15. Now I know there is more to valuing the market and/or companies than simply looking at the P/E ratio; however, this broad valuation measures does not seem to be at "extreme" levels either. Another way to look at the market's P/E is Robert Shiller's method where the market P/E is based on average inflation-adjusted earnings from the previous 10 years. This methodology indicates the current market P/E is 20.6, essentially in line with the 2009 year end estimate provided by S&P.

One key to the market's future direction is to answer the question of how likely is the market to achieve the earnings results that are projected. There are several variables that could derail the earnings that are projected. I believe two significant variables are:
  1. how likely is the financial sector to incrementally grow 2010 earnings by $8 per share on average, and
  2. how will Washington policies: cap and trade, health care, etc., impact company earnings
Nearly all of the policies being proposed in Washington add expenses to companies not to mention the impact on state budgets. At a time when the economic recovery seems fragile, these added expenses are not likely to be positive for corporate earnings or municipal budgets.

Much is made of the benefit of running deficits during economic slow periods. In 1937, the Roosevelt administration and the Federal Reserve reversed liquidity measures taken to fight the Depression. This is thought to have resulted in the double dip during that time period in addition to some other factors that were not pro-business (see my post, Positive Equity Market Returns Probable In 2010). The key though is how is the deficit money being spent. The deficit funds need to be spent in productive ways that create an environment that put the jobless back to work in the private sector and not the government sector.

In summary, sentiment and allocation data appear elevated but not at extremes. At the same time the market's forward valuation does not appear too stretched. This does not mean dive head first into the market. Being selective in the companies one invest in could still provide adequate returns in 2010, but not without experiencing some volatility.

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