The Market Needs a Break, Too

08/13/2009 1:59 pm EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

It’s August, the dog days of summer, and everybody’s taking time off. Maybe the market will, too.

Stocks have had a huge run since their March 9th nadir, when the Dow Jones Industrial Average plummeted to 6,547.05 and the Standard & Poor’s 500 index hit 676.53. The Dow is up 43% in that time, while the S&P has rallied 49%. Smaller US stocks and overseas stocks, especially emerging markets, have done much, much better.

Despite Wednesday’s rally after a pretty benign statement from the Federal Open Market Committee meeting, this market has come a long, long way in a short, short time. It’s much pricier than it was back in March. The worst of the recession is probably over, but the economy’s woes will linger, keeping a lid on earnings growth. And the financial system may be off life support, but it’s got a chronic illness that can flare up at any time.

That’s why I think the easy money has been made—though it wasn’t so easy to put money into stocks back in March, was it? Even if we’re in a new bull market—which I’m not convinced we are—we’ve probably already gotten half of it, if the 2003-2007 cyclical bull is any guide.

So, I believe investors should start selling selectively (I’ll have some recommendations later), especially if they were smart or lucky enough to be buying back in March, when everyone else was looking for the nearest window to jump from.

Since then, we’ve had a “renaissance of risk” as investors fled the security of Treasuries for the riskiest asset classes, which have done best in the recent rally.

Those “high-beta” stocks—which move the most in either direction versus the S&P—have clearly profited from the many signs that the recession is over and some kind of recovery is beginning.

Using the excellent index returns calculator from Russell Investments, I came up with this table of the five best performing US markets since March 9th.

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As you can see, the stars are all smaller stocks, the very groups that got pummeled during the bear market. Microcaps set the pace, gaining 67.2%, while mid- and small-cap stocks rounded out the top five, all notching 60% gains.

But although mid- and small-cap (Russell 2000) value stocks were among the leaders, guess which sector just happens to weigh very heavily in those indexes? Financials, whose resurrection has paced this rally. That makes them most vulnerable to any correction.

Overseas markets did even better, of course, especially the riskiest, highest beta markets, as the table shows.

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You can’t get much riskier than emerging market small caps, and sure enough they wore the yellow jacket in this race, with an 84.4% return. The five best global groups I looked at were either small-cap or emerging markets or both, with Asia (except for Japan) and Latin America setting the pace.

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But especially in the US, the huge rally has pushed price/earnings ratios much, much higher. According to S&P’s senior index analyst, Howard Silverblatt, the S&P 500 now trades at a hefty 18.4x projected 2009 operating earnings of $54.08 a share.

That’s up from 12.4x operating earnings at the March 9th lows, which itself was well above the single-digit P/Es that usually characterize generational bear-market bottoms.

Some S&P sectors are trading at multiples that look, well, stratospheric: The financials change hands at a stunning 38.6x projected 2009 earnings, while the materials sector trades at 36x estimates. Both are more than double their 2007 P/Es.

And although this recession may be coming to an end technically, unemployment and the housing bust will plague the economy for years to come, and don’t count on the shell-shocked consumer to lead us out of this downturn as she did from the last two.

Meanwhile, surprisingly good second-quarter corporate earnings were attributable largely to massive layoffs and cost cutting. It’s harder to find real revenue growth in US companies today than it was for Diogenes to find an honest man in ancient Greece.

The combination of free government money and the partial suspension of mark-to-market accounting helped many financial institutions post strong numbers last quarter. But hundreds of billions of dollars of toxic assets are still on the books of banks big and small, inhibiting lending. It’s a bit of a catch-22 as banks won’t mark the bad assets down, afraid they’d have to take a big hit and dig deep into their capital to make up the difference.

I’m not optimistic the government is going to get it right on its third try to fix this mess, so the US banking system will likely be stuck in a toxic swamp for years, just like Japan in the 1990s.

So, what should you do? I have no idea how far this current rally is going to run. People like Bernie Schaeffer see the next hurdles at 1027 and 1142 in the S&P 500.

We’re close enough that I’d suggest taking some money off the table. Selling some financial stocks now is a no-brainer: The table below of the most “overvalued” markets is laden with finance-heavy value stocks.

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That sector is the riskiest, along with real estate investment trusts. This is a good time to reduce their role in your portfolio. I’d also cut back on Old Europe and developed overseas markets in general, whose minuscule growth rates make their low P/Es look less appealing.

But I wouldn’t be so quick to unload the high flyers, which actually look reasonably valued, as the table below shows.

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Small growth stocks worldwide and emerging markets, especially Latin America, are all trading at price/earnings ratios about equal to their projected earnings growth rates, according to Russell and I/BES. (And since those are calculated on trailing earnings, their P/Es are probably lower based on next year’s likely higher earnings.)

I think these hot markets are long overdue for a correction, but the data suggest small growth stocks worldwide, especially in emerging markets, may be beginning a long run that could take them much, much higher.

So, think of it as a “cash for clunkers” program: Sell the wheezy old financials and big-cap gas guzzlers and hold on to the sleek, new hybrids. But fasten your seat belts; we may be in for a bumpy ride. 

Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.

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