Investor Sentiment & Deflation Concerns

With the release of the 4Q11 GDP report by the Commerce Department on Friday, we felt it necessary to emphasize the pros and cons embedded within the data and more importantly, how it may affect our tactical and strategic investment plan.

The headline release illustrates the economy grew 2.8% in the fourth quarter of last year marking its fastest pace in eighteen months. This somewhat tempered pace of growth was below the 3% many economists had been forecasting and below the 3% pace that economists’ say is needed to make a marked difference in the anemic unemployment rate.

The report showed that most of the growth was due to a surge in inventory replenishment by business. Approximately 1.9% in the quarterly gain can be attributed to this inventory replenishment. This is unfortunate simply because this trend will not endure for long. With that, final sales advanced only slightly and much of it was from the sale of autos that had pent-up demand due to kinks in the supply chain from the Japanese Tsunami last year. Taken together, it signals softening going forward.

Taken together, this is one of the worst positive trends our economy could have asked for. Our task at hand is to determine how the inflationary outlook and most importantly the corporate profit picture will affect our investment thesis that we implemented for 2012.

Deflation Concerns?

One positive takeaway is the docile state of inflation in the economy.

Easing prices due to lower energy costs were another help to consumers. The tame inflation signals in Friday’s report bolster the case for Federal Reserve officials who argue that the central bank ought to do even more to encourage the recovery. The Fed’s preferred measure of inflation, the personal consumption expenditures price index (PCE) rose at a 0.7% annual rate in the fourth quarter, its smallest increase since the second quarter of 2010. With the Federal Reserve publically stating that short-term interest rates will remain at zero for the foreseeable future, this has many investors and economists projecting another round of quantitative easing (QE3) by the Fed.

Ironically, investors were willing to purchase $15 billion in ten year Treasury inflation-protected securities (TIPS) that are offering a negative yield. The question begs to be asked, why would investors PAY the US Treasury to take their investment dollars and invest it in instruments geared for protecting them against inflation.

Business Climate

Beyond inventory investment, business spending eased. Fixed nonresidential investment, on factories, machinery and computer equipment advanced just 1.7% last quarter compared with 15.7% last quarter. This represents the weakest results in two years and further exhibits the pattern of corporations hoarding cash on their balance sheets, a trend that has been building since the 2008 meltdown (Apple Computer, according to its latest earnings release now has an astonishing $97.6 billion in cash and marketable securities on its balance sheet).

Another positive sign for corporate America has been the growing backlog of business that companies have put forth. According to the New York Times, “Companies like General Electric and Lockheed Martin closed the year with record order backlogs, a sign that, at least for some businesses, demand is so strong that they cannot produce quickly enough. The backlogs portend solid growth in coming quarters, and suggest to some economists that the United States could weather the European debt crisis relatively unscathed after all.”

This has also translated into greater productivity increases. Consider this, the economy is pumping out more goods and services that before the great recession and it is doing it with six million fewer workers in the labor force. This will characterize greater profitability and reinforces our longer-term strategic outlook.

4Q11 Earnings Season

Analysts are expecting 4Q11 year-over-year earnings growth in the 6% range for the S&P 500. One detail that hasn’t gone unnoticed is the deterioration of that quarterly forecast over the past several months as analysts have been ratcheting down their quarterly earnings expectations. Analysts were looking for 4Q11 earnings growth as high as 14% in early September. With the global economy teetering on the edge of recession, one needs to scrutinize how these companies are reporting but more importantly how they will be guiding for the New Year and managing record cash levels that has been accumulated since the 2008 rout.

Should earnings season produce prosaic results, we could be in for a softening in the current rally that started in early October 2011. Given the amount of negative guidance to date, we anticipate another strong, albeit managed earnings season. When valuing the S&P 500, we tend to look beyond the quarter to quarter swings and focus our efforts on the longer-term calendarized earnings expectations for the index.

We wrote several weeks ago that we were witnessing similar degradation in earnings trends as analysts lowered their twelve-month outlook. Analysts shaved their forward guidance by $1.91 or almost 2% from $108.10 in early September to $106.10 from several weeks ago. This decline in forecasted earnings is significant because it resembles the trends we found in late 2007 as we entered a recession amid the housing collapse. Looking at the trends today, if the European crisis is not contained and the global economy suffers a similar “Lehman Event”, corporate earnings forecasts will follow a similar trajectory as found in figure 1.

While trying to avoid sounding too ominous, we have seen a very dramatic improvement in the corporate earnings picture since the start of the year and it has really accelerated in earnest with the official launch of the 4Q11 earnings season. As of last Friday, analysts are forecasting $107.08 for the S&P 500 in the coming twelve months. That’s up from mid-$106’s as we headed into the new year.

This increase in the twelve month forward earnings per share forecast is very encouraging in light of market valuations. Given Friday’s close of $1316.33, the twelve month forward P/E ratio stands at 12.3x. This stands in stark contrast with the seventeen year historical average of 15.0x, the trailing ten year average of 14.6x and the trailing five year average of 13.2x.

Using these historical valuation measures, one would place a twelve month price target for the S&P 500 within a range of $1412.42 to $1601.97, some 7.3% to 21.7% higher, respectively. Using an average valuation, we are placing a fair value target on the S&P 500 of $1526 or 16% higher than Friday’s close.

For more information on our strategic outlook, please see our January 9th market letter.

Bottom Line: Our shorter-term tactical outlook remains bullish and cautious. Given the favorable trends in corporate earnings, our longer-term strategic outlook remains neutral and increasingly optimistic. We are waiting for the “official buy signal” from our fundamental models before changing our stance. That may be coming sooner rather than later.

Investor Sentiment

One item we tend to track in the American Association of Individual Investors (AAII) Sentiment Survey. Taken from their web-site, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

While we do not incorporate this model into our behavioral calculations, we track the results for certain anomalies. This survey has been used in the past as a contrarian indicator.

“Investor sentiment measures have historically been used as contrarian indicators—meaning one would expect the market to do the opposite of what the data was saying. The analysis here appears to support that point.

While little may be gleaned from changes in investor sentiment, identifying extreme levels of positive or negative sentiment appears to offer a glimpse of where the markets may be headed. In looking at the AAII Member Sentiment survey, we found that when sentiment reached overly bullish levels, the markets normally responded negatively in the months that followed. Conversely, the market tended to rise when members became overly bearish.

While our results here seem to lend validity to the notion that investor sentiment may be used as a contrarian indicator, it would not be wise to base all your investment decisions upon it. Indicators such as this are best used in tandem with others so that you receive confirming signals of potential market movements. Sentiment merely serves as an additional tool when making investment decisions.

Lastly, even if you do not use sentiment data as an indicator, it is a good idea to be mindful of it. As investors become overly bullish or overly bearish, it is easy to get caught up in the herd mentality.

However, as we have shown, if you run with the herd, you might get trampled.” - Wayne A. Thorp, CFA, associate editor of Computerized Investing and AAII’s financial analyst.

Last week, the survey produced 48.4% of respondents saying they are “bullish” towards the market and only 18.9% claimed to be “bearish. These results are at extreme levels and have been for the past four weeks. Since the start of the year, investors responding to the AAII survey have been overly bullish as the percent of bullish responders has remained above 47% while those that claim to be bearish have hovered near 20%. We use a ratio of bullish to bearish respondents to attempt to capture an increasing sense of bullishness. Figure 5 shows that ratio has been above 2-to-1 for four weeks straight.

Bottom Line: Our behavioral model dictates our tactical trading outlook and that strategy remains cautiously bullish at this time. We will continue our bullish stance until such a time that our models indicate an appropriate exit from this position. We remain cognizant of creeping complacency that may be entering the market and are prepared to act.

Joseph S. Kalinowski, CFA