Stock Market Pros and Cons

My sense has been that it is a good time to buy some stocks.  The crisis in Europe comes and goes by the day as an explanation for sharp swings in stock prices, and it should be fairly well discounted by now.  A more recent concern is that slow economic growth in Europe and the U.S. will lead to lower profits than had been expected.

This second concern is one that has troubled me since the reporting of second quarter earnings.  My analysis of cash generation by companies in various sectors revealed that there has been a marked deterioration in cash generation by companies, almost regardless of whether the sector was highly economically sensitive.  Of course, companies that are more economically sensitive have had a larger deterioration in cash generation.  And remember, it is cash generation--not reported accounting profits--that determines the value of a business, public or private.

Despite this concern, I've thought that current levels are good entry points for a number of stocks, for several reasons.  Market sentiment has been nearly as depressed as it was at the major market low in March, 2009 (before the market roughly doubled).  In addition, the VIX Index of option volatility recently exceeded 45 as well, a high level that has been associated with at least interim market lows.  Further evidence of depressed sentiment is the level of short positions on the NYSE, which were recently the highest since March, 2009.

Technically, the market is oversold after its sharp fall.   The percent of S & P 500 stocks that are above their 200-day moving average is exceptionally low, almost as low as in March, 2009. Finally, earnings-based valuations are attractive, as the S & P 500 was recently at 10.7 times forward earnings estimates, which was lower than in March, 2009 (though estimates are likely too high).

Earnings-based estimates are problematic in my view, at least when using single-year earnings.  When profit margins are near all-time highs, earnings are likely near peak levels.  In addition, analyst estimates tend to be too optimistic, and even with recent reductions, are likely still too optimistic for 2012.  A cautionary point is that at the market low in March 2009, the estimated change in S & P 500 earnings for the coming year was a 20% decline; now it is a 15% gain.

In addition to my concerns about excessive earnings estimates, there has been technical deterioration in the market's condition.  The rising trend going back to March, 2009 has been broken.

After weighing these pros and cons for the market, I still favor drawing down cash reserves for purchases at current levels.  Again, this presumes that one has significant cash reserves and that stocks are below one's long-term, strategic target portfolio allocation.  If one waits until the news is good, stock prices will likely already have moved significantly higher by then.

Steve Lehman
LehmanInvest.blogspot.com/

S & P 500:  1123