Issue 22 • June 22, 2011

Finally! After six straight weeks of sliding stock prices, the S&P 500 reversed course, posting a fractional gain of one-tenth of a percent last week. Small potatoes, but we’ll take it.

This week too has begun on a higher note, leading investors to speculate whether the worst of the summer doldrums may be over. Could this be a replay of last summer’s swoon … and year-end rally?

Recall this time last year — from April 23, 2010 to July 1, 2010 — the S&P 500 Index worked through a painful 17 percent correction, but then went on to notch gains of 30 percent over the next eight months.¹

The key takeaway is that markets never move in a straight line … up or down … as evidenced by this recent pullback. Investors that pulled out after the double-digit decline in 2010 most likely didn’t time a re-entry to stocks soon enough to capture those end-of-year gains.

The message is that if you dwell too much on short-term market turbulence, you may be emotionally driven to pull out precisely when you should be buying.

Instead, take a deep breath and another look at the big picture trends.

Granted, it’s not easy to maintain a long-term focus when you’re going through a roller coaster ride of emotionally charged volatility as witnessed last summer and again in recent weeks.

But short-term weakness can still present some wonderful long-term investment opportunities.

Maintain a Long-Term Perspective

Taking a look at the market’s current valuation compared to the long-term norm, stocks look attractive with more upside potential from here.

S&P 500 profits surged 30 percent in the first quarter of 2011, and for the full-year 2011, earnings are expected to climb 18 percent over last year. What’s more, this estimate may prove too conservative as actual earnings have consistently beat estimates so far this year.²

The S&P 500 now trades at just over 14 times earnings over the past year. That’s a discount of about 25 percent below the average P/E ratio of 20.4 over the past 20 years.³

If you take this year’s expected earnings of $95.95 for S&P 500 companies and apply a conservative P/E of say 15, the index could easily move up to 1,440 by year end, an 11 percent gain from the current level.⁴

In addition to the fundamental support from strong earnings growth and reasonable valuation, market sentiment could be a positive catalyst to turn things around.

Fear Itself Could Provide Upside Potential

Certainly investors are worried about a laundry list of outstanding issues — the ongoing Eurozone debt crisis … a slowing US economy … the approaching end of the Fed’s quantitative easing … the contentious US debt ceiling debate. There’s no shortage of fear right now.

However, from a contrarian perspective, you’ve got to look at the fear as a potential positive for market performance. A number of sentiment indicators we follow are showing investor sentiment is at a pessimistic extreme — one that is likely already priced into the market.

A case in point is the bullish/bearish poll recently published by the American Association of Individual Investors (AAII), a popular market sentiment gauge for decades. Typically, when we are at such pessimistic extremes, the stock market tends to post better-than-average performance near term.

Most recent results from AAII show only 29 percent of investors in the bullish camp, while nearly 43 percent of investors are bears (the rest are neutral). That’s an extreme reading compared to the long-term averages of 39 percent bulls/30 percent bears.⁵

In fact, the AAII Bull Ratio has only slipped below the 34 percent level four other times since the March 2009 market low (See graph above). After each of the previous occasions, the S&P 500 rallied significantly over the next six months, posting an average gain of more than 20 percent.⁶

Again, the history lesson here is that worrying too much about the market, as many investors are doing right now, is like following the crowd, which may be precisely headed in the wrong direction.

Instead, with negative sentiment so one-sided, we want to be on the other side of this trade, which history suggests could be the right move.

Granted, this kind of counter-intuitive thinking isn’t easy when share prices have been falling for six weeks in a row. As Banyan’s Chief Investment Officer, Michael Blackmon said recently, “Investing is the only business that, when quality merchandise goes on sale, nobody wants to buy.” But buying is often exactly the right thing to do during times of extreme pessimism. In other words, attempt to be “greedy when others are fearful,” as Warren Buffett is fond of saying.

And never forget that as investors, the stocks we buy today shouldn’t be judged by their performance over the next three months … but over the next two – three years or more.

Bottom line: What we’ve seen over the past few months suggests nothing more than a temporary downshift in economic growth accompanied by increased market turbulence. Such a mid-course correction during an expansion is normal.

Meanwhile, financial markets appear to have overshot, discounting a much slower growth scenario than we consider likely. In other words, while there are still legitimate concerns out there, the markets may have already overreacted on the downside to these worries.

While markets are likely to remain choppy until more of these issues are resolved, right now, we believe that stocks are largely oversold and overall market valuations do not yet appear excessive. In fact, several sectors and individual high quality stocks look quite attractive to us right now.

Don’t forget, too much pessimism on the part of investors may actually help fuel a near-term rally.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. Be on the lookout for your invitation to our upcoming quarterly conference call, exclusively for Banyan Partners clients. We’ll discuss our outlook for the second half of 2011 and provide answers to your pressing investment questions.

The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to the economy, industry or investment opportunity mentioned in this report. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

¹ Bloomberg market data, 6/21/11
² Bloomberg: Stocks Cheapest in 26 Years as S&P 500 Falls, Earnings Rise 18%, 6/20/11
³ Ibid.
⁴ Thompson Baseline, 6/21/11
⁵ American Association of Individual Investors, 6/15/11
⁶ Ibid.