Are Equities Still Cheap?
By Chris Maxey, Ryan Davis
November 27, 2012
Housing Data Surprises to upside
Equity markets bounced back in a holiday-shortened week, with triple digit gains in the Dow occurring on Monday and Friday. Rumors of compromise in Washington regarding the fiscal cliff and better-than-expected housing data pushed stocks to their biggest one-week gain since early June. For the week, the S&P 500 and Dow Jones Industrial Average rose 3.6% and 3.5%, respectively.
Economic data was very strong last week, led by a series of positive housing indicators.
On Monday, both existing home sales and the housing market index surpassed economists’ expectations. Existing home sales increased to an annualized rate of 4.79 million in October, up 2.1% from the prior month and 10.9% from one year ago. According to Lawrence Yun, NAR chief economist, there was some impact from Hurricane Sandy. "Home sales continue to trend up and most October transactions were completed by the time the storm hit, but the growing demand with limited inventory is pressuring home prices in much of the country," he said. "We expect an impact on Northeastern home sales in the coming months from a pause and delays in storm-impacted regions."
Indeed, housing supply fell to its lowest levels since February 2006, reaching 5.4 months. Distressed transactions, which have also been falling as a percentage of sales for some time, remained unchanged from September. Distressed sales, which include both foreclosures and short sales, accounted for 24% of existing sales. This is down four points from 12 month ago and represents a significant improvement from the depths of the housing crisis.
The National Association of Home Builders’ (NAHB) monthly Housing Market Index (HMI) rose five points to the highest level since May of 2006. The metric, which gauges homebuilders’ perceptions of current sales, sales expectations for the next six months, and prospective buyer foot traffic, saw two of its three components improve in November. The current sales component was the biggest driver of the index gain, as it improved by eight points. Prospective buyer foot traffic was unchanged in the month.
A seventh consecutive gain in the HMI provides additional evidence that the U.S. housing market is firming. Demand for new homes is improving as housing supply falls and the level of distressed inventory diminishes. NAHB Chairman Barry Rutenberg noted many buyers are motivated to take advantage of low interest rates and housing prices still at discounted levels.
The good news continued Tuesday when the Census Bureau announced housing starts gained 3.6% in October. The seasonally adjusted rate of 894,000 new units was 41.9% above year ago levels, and was surprisingly resilient following September’s 15.1% jump. Economists expected the series to give back some of those gains this month, with consensus calling for an 836,000 rate.
Housing permits were a bit less impressive, softening 2.7% in the month. Permits were weaker in every region but the Midwest, with notable weakness in the Northeast. That may change in the coming months as rebuilding efforts get underway following Hurricane Sandy. The Commerce Department made special note that houses needing to be completely rebuilt will be counted as new homes, under the amended definition created in 1992 following Hurricane Andrew.
Although housing data dominated the week’s economic headlines, the first release of consumer sentiment for November was released on Wednesday. Market participants closely eyed this report following a recovery high reading in October. Predictably, the series did weaken, but only modestly so. Consumer sentiment fell from 84.9 to 82.7, which was slightly below economist estimates. The primary source of decline was the expectations component, which fell slightly more than three points. Even after the decline, consumer sentiment is at its second highest level since the economic crisis ended.
Are Equities Still Cheap?
Since reaching a near-term top in mid-September, the S&P 500 Index fell more than 7%. After a 4% rally in the last five trading days, there are reasons to believe equity markets are poised to extend recent performance despite headline concerns.
One of the more popular contra-indicators is investor sentiment, which tends to ebb and flow in the same direction as the markets. In the past several weeks, investor sentiment has turned decidedly bearish, in line with deterioration in equity markets.
The most recent AAII Investor Sentiment Survey, which asks for investors’ opinions in the next six months, showed that 40.8% of investors were bearish on the outlook. That is well above the long-term average of 30% and was only that low due to an eight-point decline from the previous week. There were 35.8% of investors in the bullish camp and 23.4% neutral on the market’s outlook.
Source: Schaeffer’s Investment Research
At current readings, the number of bearish investors is similar to August 2011 and May 2012, both periods just prior to an equity market rally.
The seasonality factor is also important. Over the last decade, December has consistently been one of the strongest performing months of the year. Returns in December averaged 1.25% during that time, the third-best month behind April and March.
Source: Schaeffer’s Investment Research
Seasonality should also play a role looking towards 2013. The website Decision Point recently highlighted work from the Trader’s Almanac showing that markets are seasonably unfavorable between May 1 and October 31. From November 1 through April 30, though, markets generally trend higher. The same phenomenon played out over the past 12 months.
Over a longer horizon, price-earnings ratios suggest there is still plenty of room for equities to rally. Bloomberg reported current P/E ratios are below the ending level for eight of the last nine bull markets. In order for the S&P 500 to reach the average bull market P/E, the S&P would need to rally 26%. If analysts’ earnings forecasts for 2013 are accurate, the S&P could see a more than 40% gain to reach the average P/E.
Even though equity markets appear cheap by most valuation and technical standards, there continues to be a massive headwind from a macroeconomic standpoint. Economists are concerned about the fiscal cliff, slower growth in China, and the tenuous situation in Europe. Markets are already pricing in each of those concerns. If we see small pieces of positive news begin to develop, it will represent a positive tailwind for markets entering the new year.
the week ahead
Investors will be welcomed back from the holidays with a full slate of economic data. More housing data comes in via the Case-Shiller Home Price Index and new home sales on Tuesday and Wednesday, respectively. On Thursday, the second estimate of third quarter GDP is due out from the Bureau of Economic Analysis, with economists looking for a near-1% increase from the first estimate of 1.9%. On Friday, the same agency puts out data on personal spending and incomes.
On Monday, a meeting of European officials is expected to result in a final agreement on the latest round of aid for Greece. Barclays Research predicts the meeting will likely yield €44 billion in financing for the troubled country.
Several central banks are scheduled to meet this week, including Israel, Hungary, Brazil, Thailand, and Mexico. Hungary and Thailand are expected to cut rates.
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