Weighing the Week Ahead: Priced for Perfection?
With a stumble in tech stocks this week, nearly everyone is asking two questions:
- Is the long-awaited correction upon us?
- Will it be a normal pull back, with buyers stepping in, or the start of a big decline?
If you really want to frighten people, just use the phrase “priced for perfection,” as Herb Greenberg did in this CNBC segment.
I am a long-time Greenberg fan, back from his SF Chronicle days. He does good investigative reporting. His sources have always been mostly bears and short-sellers, so he has needed to learn how to use this information without being manipulated. In general he does a good job in navigating these waters.
The piece I am citing raises some issues. How typical are the stocks cited? Let us suppose that we have a stock with forward earnings of $1.50 and earnings growth of 40%. Some investors might give this a P/E multiple of 40 (a PEG ratio of only one) and figure it is a $60 stock. Now let us suppose that the stock reports a quarter of 30 cents instead of the expected 35 cents. Two bad things happen:
- The expected forward earnings come down a notch — perhaps to $1.35.
- The growth rate goes to (maybe) 25% instead of 40.
Now the growth investor does a 25 multiple on $1.35 and it is a $34 stock. In growth stocks, an earnings miss affects both the earnings forecast and the growth rate. This changes the multiple accorded by the market.
A stock price that reflects maximum potential earnings and growth is the definition of “priced to perfection.”
Greenberg came up with some examples, but are these typical? And what about the “weak hands” thesis?
I’ll conclude with my own answer, but first let me do my regular weekly review of data.
Background on “Weighing the Week Ahead”
There are many good services that do a complete list of every event for the upcoming week, so that is not my mission. Instead, I try to single out what will be most important in the coming week. If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media. It is a focus on what I think is important for my trading and client portfolios.
In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. Others will disagree. That is what makes a market!
Last Week’s Data
We had some important data last week and it was pretty positive.
Major economic indicators continue to beat expectations.
- Economic growth is improving. The ECRI weekly leading index rose to a 36-week high last week, and the growth index, now in positive territory for a fourth week, is at a 34-week high. The ECRI said several weeks ago that a near-term recession was off of the table. Each week we have more evidence that they are correct. Investors should think about the growth index as an acceleration term, while the WLI is a level. The bearish punditry focused on the acceleration term when it was negative. Please check out this interview to contrast the ECRI posture with outsiders trying to interpret their data, especially David Rosenberg. The current ECRI verdict? “With WLI growth rising for ten straight weeks to a 33-week high, U.S. economic growth will soon begin to revive,” said Lakshman Achuthan, managing director of ECRI.
- Risk as measured by the St. Louis Fed Stress Index, edged slightly lower, remaining at a very low level. This measure tracks a lot of market data in the eighteen inputs. It is not a poll, nor opinions, nor a collection of anecdotes. We should all pay attention to some real data. The value moved to .056, down slightly from .122 last week. For more interpretation, the St. Louis Fed published a short paper with a very nice chart that helps to interpret this index. The chart does not reflect the recent continued decline in stress, but it identifies the dates for important recent events. The paper also has a longer version of the chart, illustrating past stress periods. I am not going to run the chart each week, but I strongly recommend that readers look at the paper. In the 2008 decline there was plenty of warning from this index — no sign right now.
- China, Obama, and Policy Changes. The relationship is complex and everyone is spinning away. There was some meaningful trade and currency progress, but intellectual property is still a key issue. Meanwhile, The Old Prof remembers Nixon and Kissinger in 1972. No Democrat could have pulled this off. It defined a new era. Clinton and NAFTA did the same. Those who think that Obama and and the 2010 election means gridlock have a poor sense of history. Big changes sometimes come when the leadership goes against traditional party positions. We are already seeing this.
- Jobless claims — still not good, but reversing last week’s spike. I’m calling it good news on a weekly basis.
- Building permits. The overall housing report was not impressive, but building permits surged 16.7%. Regular readers know that I am not cherry picking this as an indicator. I have always maintained that this is the best forward look at housing. Permits require a serious commitment.
The bad news centered on inflation potential and housing.
- The Philly Fed Index was actually good economic news, but the market, poised to anticipate any possible correction, seized upon the uptick in pricing expectations. Calculated Risk covered this in a balanced way and Rick Santelli explained the market reaction. Objective readers may well wonder how one can move seamlessly from worry about deflation and economic collapse to inflation.
- Existing home sales still lag. Calculated Risk explains why the picture is not as good as the official data suggest.
- Earnings reaction. The earnings news has been solid, but the reaction has been skeptical. Every pro watches this as a sign of how much the market has “built in” earnings growth.
The ugliest thing I see this week comes from my email flow. There are three distinctly different distrubing sources:
- One guy sends me the worst possible news every day — what the US is doing wrong, what Europe is doing wrong, the fragile nature of all economies, etc. A typical piece highlighted an aritcle in ZH with a hat tip to a breathlessely appreciative guy who had been published there recently with hundreds of comments. He is explaining why the ZH exposure is so much better than SA. The fawning guy cited a piece in the Bond Buyer showing how investors were getting paid back a few cents on the dollar. The same issue showed an article warning that the crisis was overblown. There is no attempt at balance in this. I do not know exactly how everyone profits from selling fear, but the industry is a big one. 60 minutes and CNBC should spend some time on this topic.
- An old and dear friend celebrated her 70th birthday today. She has decided to spend her time forwarding Internet lies and trash to hundreds of people. This includes dozens of stories refuted on Snopes — basically attacks on Obama, immigration, taxes, and the economy. The most recent one falsely stated that the President canceled national prayer day and prayed with Muslims instead. It showed a picture of one of his world travels in a scene that might have applied to any President.
- There are comprehensive reports showing numerous similar periods in history. Many of these go back to the 19th century to show people why the current rally cannot possible move further. Why we care about the “dead ball era” amazes me. I am also surprised that people who look at a rally do not look at the starting point. If earnings are growing faster than stock prices, the rally is not overdone. End of story. But that part is not mentioned in these reports.
This email is hateful deception. The stories are unbalanced coverage at the best, and blatant lies at the worst.
There are victims — real victims. I am going to pick two different clients, both discussing investments with me last September. One potential client reads all of the Internet pundits every day. She was worried about all of the stories about Ben Bernanke and QEII, so she stayed in cash. The other worked with me to develop a balanced portfolio related to personal needs — ignoring the noise about politics.
The first potential client was the victim of the Internet noise, the stupid bunnies, and the general climate of fear. The second had the wisdom to focus on his personal mission and ignore the noise and the politics.
I admit to some emotion tonight. I am unhappy with my old friend for peddling fear because she does not like the President. There have been many Presidents that I did not like, but I tried to be honest in my comments and objective in my investing. I am also feeling a sense of personal failure because I could not explain to the intelligent and deserving potential client why she was being bamboozled. She and her husband have earned and deserve a better retirement.
This is a story that plays out daily for me. Nearly every investor I talk with has been bombarded with messages of fear. It helps to explain why I am not very influenced by poll-based sentiment indicators that say everyone is bullish. It does not square with reality.
Our Own Forecast
We base our “official” weekly posture on ratings from our TCA-ETF “Felix” model. Felix has captured the big rally since last September, usually in the best sectors. The ratings are showing more of a mixed tone. It is a close call, but we are continuing our bullish position in the weekly Ticker Sense Blogger Sentiment Poll. Here is what we see:
- 79% of our 56 ETF’s have a positive rating, up nicely from 61% last week.
- 46% of our 56 sectors are in our “penalty box,” about the same as 48% last week — still in warning terriotry.
- Our universe has a median strength of only +14, but strengthening from +7 last week, and reversing the recent decline.
The overall picture is a little stronger. While we maintened a 100% long posture, we are watching the indicators quite carefully.
[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list. You can also write personally to me with questions or comments, and I’ll do my best to answer.]
The Week Ahead
There is a lot of data next week. I do not expect much of a move from the Case-Shiller housing data or the government price data. There is too much complexity and spin related to foreclosures and shadow inventory. Nothing would be accepted as good news.
There will be the Fed announcement, but no one is expecting anything new.
The State of the Union is the most important event. Usually I have an idea about what to anticipate, but there is a lot of mystery this time. I will watch with interest, but I expect any surprises to be market friendly. That seems to be the message of the recent Obama changes.
The first read on 4th quarter GDP will come out. The perma-bears are now ratcheting up expectations in the near term and moving forward their predictions of doom to the second half of next year. Whatever the number, the market is already looking ahead to 2011 and more earnings.
Is the market priced for perfection?
The market is attractively valued on one-year forward earnings. I have shown these to be accurate and no one has stepped up to challenge the data.
The P/E multiple is likely to increase based upon my analysis of past data. David Tepper called the move starting in the last quarter, mostly emphasizing the asset allocation choice faced by many big players. He repeated the story last week citing S&P 1522 in about two years (HT again to Mike C).
There can always be a correction, especially after a big move. Most skeptics have been predicting this every week for seveal months. The individual investor needs to focus on these three facts:
- The market is attractively priced on a forward earnings basis (the best measure) with current interest rates in mind.
- The economic prospects via the objective ECRI measure are very good.
- The risk — via the SLFSI measure — remains very low.