David Joy: Have stocks peaked?

Despite a lackluster trading session on Friday, stocks nevertheless delivered another weekly gain, as the S&P 500 rose 0.6 percent. It was the fourth week in a row of higher prices, and tenth in the 11 weeks to begin the year. In fact, the S&P has suffered only 18 down days of the 51 so far this year. The index is only five points, or 0.3 percent below its all-time high reached back in October 2007. And the pace of the market’s ascent has reaccelerated somewhat in the past few weeks. It rose 5.0 percent in January, but then just 1.1 percent in February. Now in March it has climbed another 3.0 percent in just over two weeks.

But just as a rising chorus of calls for some kind of correction permeated market commentaries toward the end of February, the same is beginning to be heard now. The most often cited rationale is that stocks simply cannot rise indefinitely. Yet, while that sentiment has some intuitive appeal, it is hardly convincing. A somewhat better argument can be made by observing that the index is now some ten percent above its 200 day moving average. At the start of the year it was just 2.5 percent above it. The market was 6.5 percent above the 200-day moving average when it began its most recent correction of any significance in mid-October, when it fell 7.4 percent through mid-November. It was 12 percent above when it corrected 10 percent between early April and the start of June last year. So, by that one measure, the market does seem a little overextended, although there is also historical experience to suggest that this measure is not always indicative of a subsequent correction.

Another measure of over-exuberance can often be found by looking at the price of stocks relative to their earnings. According to Bloomberg, the price-to-earnings ratio on trailing earnings in the S&P 500 has climbed from to 15.4x from 14.2x since the start of the year. While that is not expensive historically, the move has eliminated some of the cheapness in equities, but not enough to indicate overvaluation. Others point to elevated sentiment as a contrarian indicator that stocks prices are stretched. The American Association of Individual Investors Sentiment Survey counts 45.4 percent of investors bullish as of March 13, compared to an historical average of 39 percent. At the January 3 survey, just 38.7 percent were bullish. In fairness, however, the percentage bullish sentiment was as high as 52.3 on January 24.

i And even though volume has been relatively light during this rally, market breadth, or the number of stocks rising compared to those falling, continues to rise, indicating a healthy advance. Stock buybacks and investor flows into equity mutual funds are also supportive of prices. Credit spreads are as well.

So, on balance, although this rally may be a little stretched, the evidence is not compelling that it is running on fumes. But there is a growing sense that in order for it to continue, it must increasingly rely on solid fundamentals. At least for the time being, the Federal Reserve remains exceptionally accommodative. And the economy has shown evidence of improvement, especially in housing, manufacturing and employment. That needs to translate into earnings growth. According to Standard & Poor’s, year-over-year estimates for operating earnings in the first two quarters have been revised lower recently, to 5.4 and 8.3 percent respectively, but would still be a solid showing if realized. Second half projections are more aggressive. Of course, not everyone thinks earnings will be up this year, or at least not by much. If so, that reality could put a big dent on sentiment going forward. Stay tuned.

The Week Ahead

The Fed meets on Tuesday and Wednesday this week. After the apparent misreading of its minutes from the last meeting, the language of its statement will be scrutinized especially carefully. But it seems ironic that that in an era when the Fed has endeavored to be more transparent, and use the power of its language as a policy tool, that investors were as wrong as they apparently were in their interpretation. Despite subsequent assurances from the chairman, and insistence that meaningful improvement in labor markets are a necessary precondition to any change in policy, markets are anxious that QE3 could be reduced as early as the third quarter of this year. And while such an action would ultimately be a vote of confidence in the economy, the scaling back of liquidity support would result in a period of adjustment for both stock and bond markets. The question is when.

It is also a big week for housing. The National Association of Homebuilders index, housing starts and building permits, and existing home sales are all scheduled for release and each is expected to evidence the ongoing acceleration in housing activity, one of the key supports of this phase of the recovery.

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