Valuations are attractive
Our market timing indicators, which gave us a full house sell signal in June (see A Full House Sell Signal, June 4, 2007), are now at much more attractive levels. We don’t have a strong buy signal yet, at levels of -2 on the CVI or the capitulation indicator for instance, but both these indicators were very close to -1 on August 16. This means that the correction we have experienced was equal to an average bull market correction, and the entry point is attractive. With a score below 0 on our Composite Market Timing Indicator, like we had in the second half of August, the average next 6 month performance in equities has been 7.7%, with the market having been up in 81% of observations.
If you believe the earnings, PE ratios are very low. We are the first to admit that reversion-to-the-mean of margins and earnings levels is inevitable, as the law of economics dictates, but reversion-to-the-mean will only happen in the next recession. As long as top-line growth comes through, cost pressure can be absorbed through growth, and margins can stay close to their current peak levels. This indeed has been the pattern observed in the last few years of previous bull markets. If earnings are roughly right, PE ratios are very attractive.
The share of the market that qualifies as a Benjamin Graham Value stock is at an all-time high, as we show in Exhibit 20. Again, this conclusion does depend on whether earnings are sustainable or whether they will collapse. But there is a marked contrast between how many Benjamin Graham value stocks there were in 1998-2000, and now. The long-term average share of the market that qualifies is 5.0%, versus 16.2% today, which is the highest share of the market to qualify as a Benjamin Graham Value stock since 1992, narrowly beating the previous all-time high of early 2003.
Sentiment is negative
The weekly put-call ratios reached an all-time high in the third week of August, based on weekly data since 1995. The skew — which measures how popular put options are in comparison to call options — reached an all-time high, too, based on data since 2001. These are bullish contrarian signs, with very favourable odds that markets are up in the subsequent 6 months.
Our favourite sentiment indicator for European equities from the futures market is the CFTC data on the NASDAQ. Currently that displays a 1 standard deviation net short. From levels of 1 standard deviation shorts or more, MSCI Europe has gone up an average 9.9% in the following 6 months, up 91% of the time. We like those odds.
Our capitulation indicator, which is based on price action and the breadth of the correction, suggested that there had been capitulation in the middle of August. The reading reached on August 16 (the trough, so far, in this correction) was -0.84, compared with an average trough reading of -1 in bull market corrections in the last 25 years.
Weekly mutual fund flows into emerging market equities showed an outflow in the week following August 16, consistent with market troughs. When the retail investor starts selling it is often a sign of the trough having been reached.
Finally, as mentioned earlier, most people are now staying on the sidelines, waiting for more clear signs as to whether they should be bullish or bearish. Investors who can use leverage to increase their gross exposure are using a much lower amount than usual, and our strong sense is that most deleveraging among stat arb and quant funds has been done. There are plenty of sources of money to be invested in equities, potentially, from asset allocaters, retail investors, hedge funds by increasing their gross exposure, corporates by using their strong balance sheets to embark on strategic M&A or buybacks, sovereign wealth funds and uninvested private equity.
Continued…
