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VERSACE: Healthy pullback of stocks looming?

- The Washington Times - Friday, September 4, 2009

OPINION/ANALYSIS:

Through the end of August, the stock market was up 16.3 percent since the start of 2009 as measured by the S&P 500. Breaking that down, the market rebound of 39 percent since early March more than offset the 19 percent fall in the index during the first two months of the year.

With the summer more or less behind us as the Labor Day holiday weekend looms, the big question on the minds of individual investors as well as the professional ones is, what's next? A September sell-off or a cooling off from the recent market rally before another bull run?

Why are investors concerned about a September sell-off?

Historically September has been the worst performing month for the Dow Jones Industrial Average as far back as 1900. Collected monthly performance for that index from 1900 to 2008 reveals that on average September has generated a loss of 1.1 percent. In fact, outside of February it's the only month in which the Dow has had an average return on the negative side.

Independent of this September phenomenon, the past several months' run-up in the market has led to valuation concerns. In its simplest terms, valuation determines the current worth of a company's stock share price, with several techniques being used to determine that worth, both subjective and objective - the latter tending to focus on future profit and earnings generation. With that in mind, the consensus Wall Street expectations of S&P earning for 2009 is $52.94 per share, which means the S&P 500 overall is trading at 18.8 times those expected earnings, a figure known as the "multiple."

In the professional investor's mind, the current valuation appears stretched, especially when viewed against the backdrop of current earnings growth or the lack thereof. As such, its somewhat surprising to see Standard and Poor's raise its price target for the S&P 500 to 1,100 from 1,015, which would amount to an 8 percent rise from its Aug. 31 closing value and equates to 21 times current earnings expectations.

A few comments on that earnings outlook. The current earnings expectation for 2009 is not only down 20 percent compared to 2008 earnings but it is down from prior expectations this past March that called for the S&P to generate $61.22 in earnings in 2009. As those expectations fell, the market rally resulted in multiples expanding from 11.1 in March, based on 2009 earnings expectations at the time, to the current multiple of 18.8 on revised expectations.

To be fair, market valuations in March were, in hindsight, unsustainably low as we started into the abyss. Since then, however, the multiple expanded 64 percent, while economic indicators have suggested what at best can be called a stabilization, as most of the data is more "less bad" than "good." Many will point to the recent upward movements in the Chicago Purchasing Managers' Index, July factory orders and the ISM Manufacturing Index for August. True, all three were up month over month but, to be fair, it's no secret that inventory levels were unsustainably low and that current activity likely reflects the return to more normalized levels at best.

Case in point, corporate earnings in the June quarter were for the most part "better than expected." Two things to point out: as mentioned above with those lessened expectations for the S&P 500, expectations for corporate earnings in the June quarter had been lowered in the preceding months. Second, more than a fair number of companies beat expectations largely due to cost-reduction efforts, including layoffs, while they missed revenue expectations. As I have said previously, the notion of cutting our way to growth is like looking for a unicorn.

As I write this, we are getting an early read on August retail sales and reports that are mixed. The Limited, BJ's Wholesale Club and the Gap, while doing better (or "less bad") than expected, still posted declining sales. At the same time, such others as Macy's, Saks and JCPenney reported data for the month that was worse than expected. This follows data from Johnson Redbook retail sales index for the week ending Aug. 29, which was worse than in previous weeks.

The net takeaway in my view is that the days of the stretched consumer are over and when people do spend, they are going to be very selective. As such, the key indicators to watch in my view will remain disposable income, jobless claims and the unemployment rate. Continuing jobless claims edged up this week to 6.23 million as the weekly jobless claim numbers held firm at 570,000. Meanwhile, ADP Employer Services said employers cut payrolls by 298,000 last month compared with the median economist estimate of losses of 250,000. Keep in mind, the ADP data reflects only nonfarm private employment and excludes public or government related metrics.

Clearly, investors will be focused on the unemployment report for August and its outcome will likely decide if we are in store for a bumpy road or a more pronounced stock market pullback. Looking ahead, a continued climb in unemployment from here will soon call into question earnings growth prospects in 2010 for the S&P 500 and individual companies.

Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@washington times.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.