Monday, November 27, 2006

Comments from Street Insight

This is Part 1 of my commentary from last week on Street Insight. I filled in for Doug Kass on the site last Monday, and wanted to repost some of my comments from that day:

It is nice to be back in The Edge this morning, filling in for Professor "K." I should say right up front, if you haven't seen my posts in Market Insight, that I do not share the ursine views of my colleague. I am very bullish on the market, both for the remainder of this year and also next year. While we could obviously get a pullback at any time, I continue to believe the environment is conducive for higher equity valuations.

Strong Markets Trade Sideways While Working Off Overbought Condition
There is no denying that after the advance the market has enjoyed since late summer, that we are now overbought and in need of a pause. But strong markets often merely trade sideways while working off their overbought condition, and don't offer a perfect window for underinvested managers to get in. Moreover, each and every time the market makes a new high and then pulls back, there seems to be a large cohort that immediately calls it a major top, only to later claim that their call is just "early."

Preparing for the Mother of All Short Covering Rallies
I believe the market will finish the year higher than we stand today. And I see the markets putting in another double-digit performance next year as well. My pal Gary "D" has coined the term MOASR (mother of all short-covering rallies), and I agree that before the current bull cycle ends, it will likely experience just such a scenario.

The Four Legs of the Market I like to look at the market like as a four-legged stool: fundamentals, technicals, sentiment and macro/ structural. So let's take a brief look at each and I'll offer some color on my bullish views:

Fundamentals: Profit growth was supposed to slow starting in Q306 (or before), but instead the latest figures from Standard & Poor's show that earnings growth will top +20% in the current period. So much for the slowdown. Earnings revisions continue to creep higher, and as such I don't feel that analysts have stretched at all to come up with 2007 forecasts. Valuation is still cheap, with the S&P 500 trading at a little over 15x forward estimates. With moderate growth, slowing inflation, and money coming out of energy and housing, I think we could easily see multiple expansion next year.

Technicals: The technical backdrop of the market has vastly improved, short-term overbought levels notwithstanding. The market is now trading comfortably above both its 50-day and 200-day moving averages, both of which continue to exhibit a positive slope. Money flow has supported the market, such that the ratio of accumulation days to distribution days has favored the former. And new leadership in the market has shifted from energy and materials stocks back to good ol' growth stocks. From my perch, this is another bullish development.

Sentiment: There were quite a few indicators that registered record levels of bearishness this summer. While some of these have moved back towards bullish levels, they are by no means flashing extreme bullishness yet. I believe there is still sufficient skepticism associated with the U.S. stock market that the 'wall of worry' remains firmly in place, even if it doesn't stand as tall as it did this summer. In a subsequent post, I will expand on some of the indicators that I follow, as I believe they still have room to run before a full migration to the bullish camp occurs.

Macro/Structural: The biggest factor here is the Fed, which I believe is firmly on the sidelines. This removes a considerable overhang from the market. Moreover, when they do get back into the market, I believe it will be to lower rates, not raise them. That is what the 10-year yield has been signaling for some time now. And with oil, the CRB, the PPI, and other inflation indicators beginning to roll over in earnest, lower inflation will allow the Fed to become less restrictive. Additionally, I think the Fed will inject more liquidity into the system, and the increased money supply will bolster higher equity prices.

So that's my general overview of the market. In my next post, I will touch on some specific investments (stocks) that I favor. And at some point I will work in an additional post on investor sentiment, just to expand on the comments I made above.


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