Markets In The Midst Of Turning

The market seems to be at a pause phase these last few days. We are in the process of closing out the third quarter and heading down the home stretch of a very challenging year. Valuations may begin to appear stretched and rich if we utilize a trailing twelve month basis. But reflecting upon the current low interest rate environment along with the lack of any “reportable” inflation, a higher price earnings (P/E) is easily attached to equities. What is or should follow would be the growth phase ramping up, spurring higher earnings and bringing those P/E multiples closer to the midrange levels. Another way to view this would be, since the markets, both equity and fixed income, are forward looking or anticipatory vehicles, we can look at market valuations on a forward basis. Meaning, we use earnings estimates for the calendar year 2010. Earnings estimates were entirely too pessimistic coming into this current quarter. Analysts are still being calculated and updated, but I see the range of estimates coming in between $65.00-$80.00 share. Let’s take the middle ground of $72.50 and attach a 15 and 17 P/E. Viola, we have a range of 1087-1232 for the S&P 500 index. I believe earnings will surprise many for this current quarter and future estimates will need to be revisited again.

The Leading Economic Indicator (LEI) once again turned out positive for the fifth month in a row. This is very positive for the economy and a market searching for a directional signal. The LEI is not definitively stating the US economy will be raging through 2010 but it is strongly suggestive of a continued recovery for the first half of 2010. US economic expansion as measured by GDP has received notable revisions over the previous two months. Entering this current third quarter, economists estimates on average called for a contraction of between 1%-2%. Now, with the information available estimates have swung to an expansion of between 2%-6%. This is a huge swing. Let’s take out the high (someone is looking to be the high water mark here) estimate of 6%, although with all the easy money sloshing around it could happen, and look at even the mid-low estimates of 3%. That is a 4%-5% swing for an economy as mature and in excess of $12 trillion. The stimulus, it can be argued whether it could have more targeted and the sheer enormity, but the effects, if this plays out, can no longer be disputed.

Autos, employment and housing oh my. (I couldn’t resist since MGM is re-releasing the Oz classic in HD for the 70th anniversary) These three amigos will continue to be front and center. The employment picture is improving as weekly claims continue to show modest improvement, although remain stubbornly high. Auto sales and home purchases have been aided by government enticements. We’ll get a more honest read on whether the bump up in both was a reflection of this government tax break or real pent up demand. I tend to believe in the latter. We’ll be watching over the next few weeks for non-farm payrolls if they can build upon recent improvements. August non farm showed a drop of 216,000, troubling yes, but a drastic improvement from June’s 463,000. For sure there is still much work to be done, but we must be aware and respectful of the current turn the economy is experiencing.

One note that I haven’t touch upon in recent past is the psyche of analyst, economists, market participants and even the bench warmers that missed this whole move. Investors and analysts, after having been scorched for the better of 15 months dating March 2009 on back, were reluctant to accept any good news. Think back after you and I bailed out the banks, backstopping the systemically important. Even after the US guarantee, their securities, both bonds and equities, traded as if they would be liquidated, for months. The conversation for the better half of 2009 was of which banks would go to the way side and how the US economy had lost its ability to innovate and grow. Over the last few months, the discussions have shifted from one of how to jump start the economy, to how is the Federal Reserve going to orchestrate the removal of excess liquidity. It was subtle at first, just a murmur, now the idea and conversation has gone main stream. As more and more analysts and investors buy into this assessment, capital will be deployed. I’ve mentioned one such area to keep an eye on, Mergers and Acquisitions for some signs. They are beginning to pick up, most recently a nice $3+ billion deal with Dell the acquirer of Perot Systems. Expect more and the velocity to pick up momentum. Corporations are generating huge cash flows. They’ve been hoarding cash for the better part of 2 years. As more companies get comfortable with the recovering economy and earnings/demand visibility, they will deploy that cash. As investors continue to receive data supporting a recovery and a sustainable one, they will deploy some of that $3.5 trillion sitting in cash.

At this point in the economic recovery phase there is typically a significant divergence in prognostications, especially after the severity of the recession we may just be exiting. This leads some traders to have a spasmatic trading trigger finger and can create for whipsaw trading. For now, the technicals remain strong. Higher highs. An expansion in the number of stocks making new highs. Low number of stocks making 52 week lows. Stocks trading above their 50 and 200 day moving averages. Couple that with Institutional managers that missed this move and are running out of time to make up for underperformance. Oh yeah, that $3.5 trillion sitting in cash. I’m not saying we may not still have a bout of profit taking. But, that $3.5 trillion hoard, now that’s stimulus.