S&P 500 Index P/E Ratio

The current sell-off over the past several weeks in US stocks has reached the point at which smart money investors are starting to see value appear. This is by itself no guarantee that further lows will not be reached, but it suggests that we have entered the part of the selling in which an increasing proportion of sales are involuntary liquidations (driven by mutual fund redemptions, margin calls, or a need to cut risk exposure). Of course this is the major reason that the maximum pace of price decline typically takes place right at the end of a correction, which we saw at the beginning of this week.

Below is a chart of the S&P 500 index showing index price (white line), current P/E (green, right side) and Bloomberg Estimated P/E (red, right side). While the price level of the index is no lower than it was for much of Q4 2009, the significant recovery in both the level of US corporate earnings means that the index is trading at an estimated P/E of just under 13. To put this in perspective, the 13 level was only breached during the period of October 2008 to March 2009. Furthermore, during that period of crisis, estimated earnings were being cut at a rapid pace, making a low estimated P/E a much less reliable guide that value was being established than at the current time.

If we couple this P/E ratio decline with the increase in mutual fund redemptions over the past two weeks, increase in bearish sentiment, the decrease in dumb money confidence, and the increase in smart money confidence, we are reaching an attractive valuation point for a good risk/reward opportunity. We are not saying the end of this correction has definitely occurred and it is possible that even deeper value may be created by the time the downturn has run its course; but we are likely closer to the end of the move than the beginning.

Volatility is Back!

Back on April 16, we discussed how sentiment was reaching extremes with dumb money very confident in the markets, while smart money was not confident. See link to article below:

http://brightassetmgmt.blogspot.com/2010/04/sentiment-going-parabolic.html

Now sentiment has turned 180 degrees. Volatility has increased as fear now dominates where just a few short weeks ago, greed took center stage. See chart below courtesy of sentimentrader.com:

Dumb Money Sentiment has declined to 33% confidence, while Smart Money Sentiment has climbed to 50% confidence; one of the highest readings since March 2009.

As we discussed in the April 16th update, we believed any correction or decline in the markets as a result of extreme sentiment readings would likely translate into an opportunity in undervalued areas of the markets' given the improved economic picture. While we expect volatility could continue in the short-term and markets move lower, the increase in smart money confidence to 50% coupled with a decline in the markets of over 10%, and the fact the dumb money is becoming more fearful, makes us confident that a decent rally could be coming in the weeks/months ahead.

The key is having patience as well as the courage to act against the crowd...

The Deadly Web of Debt

We thought the easiest way to understand the debt issues in Europe is with a picture. Below is a graph that was posted in the NY Times several days ago. It is a fairly accurate depiction of the debt issues facing the Euro Zone. (Double click on picture for larger image)

Something Wrong with the System

Apparently, the markets dropped 10% in a matter of minutes yesterday because a "fat finger" trader mistakenly hit the "b' key instead of the "m" key. Fortunately orders don't trade that way and our sense is that the stock exchanges needed a "reason" for the media. Our feeling is that the system broke yesterday and we started to crash until the powers that be stepped in to keep the markets from imploding. Case in point, while we were looking to purchase various positions during the craziness, there were large spreads between the bid (sell price) and ask (buy price) one minute and all of a sudden there was no market. No bid, No ask, nothing. Stocks just don't trade like that even under heavy amounts of selling. Something happened yesterday that is not normal and shows that something is wrong with the system. We hope someone figures out what happened.

Why does this matter? Because our system is built on credibility, trust, and confidence - confidence in the process. Credibility and loss of confidence was at the heart of the financial crisis in 2008 and could become an issue once again. Psychology is a delicate animal and can turn vicious when the "real" comes to the surface.

Now from where we sit the last thing we want is for the market to crash as it wouldn't be good for anyone. However, it is within the probability spectrum and an outcome we must respect. Yesterday was a great example of "expect the unexpected".

So what does one do? The key is not to panic, but to act rationally. The worst of the downside may have already happened - emphasis on the word "may". According to reports, all of the unusual trades on the major exchanges that happened between 2:30 and 3:00 yesterday will be cancelled. This could add some stability to trading today but also means that people that panicked and sold positions yesterday will have the trade cancelled, so they could decide to sell at some point in the near future.

It's highly likely that markets will remain volatile over the coming weeks as news from Europe and currency markets take center stage.

In times of crisis and high levels of uncertainty it's better to error on the side of conservatism and position accordingly. Cash can be the great neutralizer in volatile times. While it doesn't help you when the market goes up, it doesn't hurt you when the market goes down. Plus, it's always good to have capital on hand to take advantage of opportunities. We have to remember that the capital markets will be here tomorrow and there will always be opportunities.

The good news from yesterday's free fall is that dumb money sentiment is beginning to turn more negative after several weeks of europhic numbers; while smart money sentiment is beginning to turn more positive (see recent weekly updates). This sentiment shift could be setting the markets up for a decent multi-month rally.