At first blush it seems that Treasury Secretary Tim Geithner’s long awaited Public Private Investment Program (PPIP), that may invest up to $1 trillion in order to remove toxic assets from banks’ balance sheets, spurred this fantastic market rally. This continues the ‘shock and awe’ coordinated approach to flooding the system in liquidity. We do not believe that the PPIP is a silver bullet as there are plenty of buyers willing to work with the Treasury, the Fed and the FDIC in buying distressed assets. However, will there be any sellers in this auction process by the banks that hold these assets. Also, we had stronger than expected existing home sales for February announced today. Yes these nuggets sparked today’s rally but there are a few underlying items that have led to this bear market rally.
As Bespoke Investment pointed out recently, the Dow Jones Industrial Average continues to trade below it’s 200-day moving average. It has now been 220 days we have been under this average and it is the 11th longest such streak in the Dow’s history and the longest since 1982. Clearly this is a medium term oversold condition that indicates a potential rally to the 200-day moving average.
We continue to see a tremendous amount of cash on the sidelines. While this is not a reason to invest in stocks, at the margin this could fuel a continuation of this bear rally. There is more cash on the sidelines than the entire market value of the S&P 500 Index and in terms of the Wilshire 5000 Index cash equates to 90% of the total value. Just a little ripple can create a wave.
From a valuation standpoint the 10-year P/E ratio and Tobin’s Q both point to a market that is slightly undervalued based on earnings that are continuing to decline. Over the last 128 years the smoothed 10-year P/E ratio has averaged 16x for the market as a whole. Even after today’s rally we stand at 14x. This compares to a 10-year P/E of 44 in 1999.
Another measure is Tobin’s Q, which is the ratio of stock prices to book value or the replacement ratio. Over the past century, the Q has averaged 0.65 according to Andrew Smithers. Today’s Q reading is 0.5, which is double that of 2007.
Again these are not valuation levels we saw during the Great Depression, but continued coordinated actions by our Administration and others abroad could help avoid another depression. We advise investors not forget their breaking point that we visited a short two weeks ago and not be afraid to take money off the table in stocks as this rally continues and look to the corporate bond market, convertible market and commodities to further diversify their portfolios.