October 9, 2007
It is no secret that Berkshire Money Management attempts to quantify investor sentiment (bullishness vs. bearishness) in terms of supply and demand so as to try and pick market movements (as well as the magnitude of such movements and if they can/should just be ignored or if, in fact, they are the seed of proactive reallocation). Recent bullish sentiment is one of the things that suggest that we could have a re-test of the August lows (not uncommon for these types of standard, run-of-the-mill ten-percent corrections).
The American Association of Individual Investors (AAII) as well as the Investors Intelligence survey numbers are about as bullish as they have been in a year, and both about where they were before the February-March correction. As of last week the three-week average of the AAII survey showed 47% bulls and 30% bears; in late February the survey showed 49% bulls and 28% bears. The three-week moving average for the Investors Intelligence survey is 55% bulls and 26% bears; in late February the survey showed 51% bulls and 22% bears.
This points to a correction of some unknown magnitude, (but nothing that will de-rail what looks to be a positive Q4 2007 and Q1 2008) sometime in the next month or so. But what is interesting is that in the four weeks prior to the February market top, cash flow into equity mutual funds averaged $7.6 billion per week. The current four-week average is just $2.9 billion. Obviously this lends itself to several different interpretation possibilities, but the most likely is that the little guy – the investor who historically makes sentiment readings meaningful and reliable – has still not fully committed himself to this market.
Stock market indices have reached new and long-time highs, but the buying volume has more to do with the cash that decamillionaires and hectamillionaires are putting into large, active hedge funds (there are over 9,000 hedge funds) and less to do with the “average” millionaire. And we cannot count out corporate buybacks. In the first quarter of 2007 (the last quarter for which there is full data), US companies completed a record of $117.7 billion of stock repurchases. That was the sixth consecutive quarter of $100 billion-plus buybacks. In 2006 there were $432 billion of buybacks and most estimates have 2007 over $450 billion.
One research firm helping us to understand where the money is (or rather, is not) coming from is the Bank Credit Analyst which tells us that household-equity positions as a percentage of broad money-supply measures (including cash, money markets, savings accounts, CDs, etc.) have been about the same since 2004 – despite much higher stock prices. Even given today’s lower interest rates (which typically push cash into equities in search of a better return) the equity exposure levels of today (and the last few years) are about the same as 1995 and 1996.
We can take some time to speculate why this is true (a hangover effect of the 1999 party where investors are afraid to get burned again, more cash funneled into real estate, more sophisticated diversification strategies), but the point really is that this cyclical bull market – now five years old – has yet to see the usually more speculative and reckless little guy pile in. And they always do just that at the end of bull market. And that just about always forecasts the beginning of the end (or at least the beginning of a crash). Small investors, to be kind, are never early; they are reliably late and tend to pile into stocks before the bull market comes to an end. It is hard to imagine that this time it is different, that this time the little guy will resist faster paced momentum and higher priced stocks.
Sure, as suggested above, a lot of cash has flowed to houses in the last five years as opposed to the stock alternative. But it is not as if the little guy has forgotten about stocks. Company 401(k)s continue to be funded and well invested. And as exampled by the purchase of foreign stocks (as opposed to domestic stocks); investor risk appetite has not been completely fettered away despite the 2000-2002 crash. The end result (good or bad) is a US stock market that still has a lot going for it (even if it does have to go through a correction from time to time).
One of the things that the US stock market has going for it is a friendly Fed. Now we don’t know what the FOMC will do at the end of the month with the federal funds rate, but they have already injected massive liquidity by buying back bonds, by lowering the discount rate and, of course, by dropping the federal funds rate by fifty basis points at their last meeting.
A second good thing that the US stock market has going for it are corporate earnings. It seems as if Q3 2007 earnings estimates are being ratcheted down daily as this looks to be a “kitchen sink” quarter where everyone wants to flush out the subprime effects of their operations. The latest earnings estimate by Thomson Financial was a meager 1.4%. But the good news is that this low bar will be easy to hurdle. Additionally, fourth quarter expectations are in the double digit range, as are the subsequent quarter estimates (hardly the stuff that recessions are made of).
A third thing that the US stock market has going for it is its valuation. A couple of the more popular metrics for the S&P 500 do look generally positive (some others not-so, but we’ll focus on those later). The price-to-earnings ratio, at about 16.5, has dropped to its lowest level since 1996. And the oft used Fed model, which compares the 10-year Treasury yield against the ratio of earnings and price (called the earnings yield), is positive for stocks. The S&P 500 earnings yield is about 5.5%, almost a full percentage point above the 10-year note, which is paying about 4.6% (essentially this means that stocks are an attractive alternative to bonds).
So, until either a recession comes or we have a large external shock, we seem to be safe from a 20% crash – at least until the little guys pile cash into the market at just the wrong time.