Most Popular ArticlesNovember 17, 2009
The indicator that has the highest correlation to economic growth is non-residential fixed investment, Davis said, and currently investment there is weak. “Consumption really needs to drop and investment needs to pick up,” he said.
Fundamentals are the core of Davis’ fourth foundation, and he said the market valuations are neutral based on “time-tested, absolute valuation methods.”
Davis looked at valuation three ways to demonstrate its neutral reading. His favorite is median P/E, which ranks all stocks based on their earnings yield and looks the mid-point. This minimizes the distortions created by differences in earnings reporting methods across companies, he said. Currently, the median P/E is 20.2 – compared to a median value over the last 40-plus years of 16.5 – and does not indicate undervaluation.
Davis said that Shiller’s market P/E, based on 10-year normalized earnings, was “near fair value but not dirt cheap.”
Based on dividend yield, though, the market is already overvalued, which Davis said was due to dividend cutbacks, particularly among financial stocks.
The fifth foundation is that investors should be “deeply pessimistic” about the market and the economy. On that measure, Davis said advisor sentiment has turned positive and objectively generates a sell signal, but he believes that sentiment could get even more positive before the market turns down.
Consumer confidence about the economy has proven to be a good indicator for the market; extreme low confidence signals the start of bull markets, Davis said.
Confidence was extremely low earlier this year and has risen lately, which is “good for the economy but still bullish” for the market.
Davis’ sixth indicator is that “major investor groups should have below-average stock holdings and large cash reserves.” Foreign investors have equity holdings well below their median value, but individual investor holdings and institutional holdings (excluding mutual funds) are just slightly below their historical median. “I don’t think institutions are really in shape to go on a big buying binge,” he said, and he rated this category neutral.
Davis referred to the “cash mountain” of excess money supply created by the Fed’s quantitative easing and said that much of this could end up going into the stock market. But, he added, he is “not as much of a bull as most people are” based on this indicator.
The final factor is “a fully oversold longer-term market condition in terms of normal trend growth and in terms of time.” Davis presented the following data:
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