Sentiment Will Get You Only So Far
By Marshall Kaplan & William Mann

If we had to identify the major reason for the equity markets' steepest climb in decades, a lightning-like rally that took some indexes up as much as 45%, we would point to poor investor sentiment. Bad sentiment? Yes, since sentiment is often a contrary indicator. When overwhelmingly negative, as sentiment was in late winter, it is a bullish signal for the stock market.


The theory is that everyone who wanted to sell has already done so and a little good news—in this case, better than expected news from the big banks – can trigger a buying stampede. Likewise, overwhelmingly positive sentiment is bearish, as everyone who wants to buy has already done so. That leaves prices high and traders edgy, quick to hit the sell button on a little bit of bad news.

As the rally was getting underway in March, the sentiment was outright lousy. The Panic/Euphoria Model, a proprietary indicator developed by Tobias Levkovich, chief US equity strategist for Citi Investment Research & Analysis was at its lowest point since the onset of the bear market, indicating that investor fear was pervasive.

The model is now in neutral territory, neither bullish nor bearish. In our view, any future improvement in sentiment may have a less pronounced impact on share-price performance, particularly in the absence of sustainable fundamental improvement.

LOSERS BECOME WINNERS

As with the rally itself, the sorts of stocks making the greatest gains, in both the US and Europe, were even more surprising. Credit concerns combined with too much leverage were triggers for both the bear market and the recession. Companies that were hit hardest in the market decline tended to be those with credit and liquidity issues.

Stocks in the companies most shunned by investors during the bear market became those most desired in the comeback. The market data tells the story. Measured by the ratio of long-term debt to total capital, the 100 most-indebted companies in the S&P 500 climbed 76%, while the least-indebted 100 gained just 37.6% from the March low through May 28. In part, this may be a function of investor enthusiasm over narrowing credit spreads. Additional factors include signs that the housing market may be stabilizing, the early impact of the government's Term Asset-Backed Securities Loan Facility and the belief that the worst of the economic downturn might be behind us.

GLOBAL PHENOMENON

This is not just a US phenomenon, either. As the chart (below) shows, global stocks are following a similar behaviour pattern. Ranking the 1,675 stocks in the MSCI Global Universe by long-term debt-to-capital metrics, the 20% with the most indebtedness performed best in the March 9 through May 28 period, up 54.5%. The least leveraged had the lowest returns, 36.2%. Some of the biggest gains were made in financial stocks, many of which had been given up for dead by investors months ago.

This leadership of lower quality, higher-risk stocks have been precedent in past market cycles, but the ferocity of the rally is striking. However, looking ahead, we believe investors will be better served by upgrading the quality of their portfolios.

Topsy Turvy – Stocks of indebted firms did better

Data Source: MSCI as of 28 May 2009

WATCH THE MARGINS

Going forward, we believe company fundamentals such as revenue growth, profit margins and return on equity (ROE) will be more important than sentiment. To be sure, first-quarter earnings exceeded analysts' reduced expectations, as many companies achieved positive surprises through vigilant cost control.

Revenue growth, however, was a different story, as businesses and consumers alike kept a tight lid on spending. Accordingly, it will become increasingly difficult to sustain any earnings gains through the remainder of the year without an eventual pickup in sales. Another fundamental factor is the sustainability of a company's return on equity. In the last market cycle, many companies boosted ROE through leverage.

With financial companies, leverage was the main driver of enhanced returns, not extraordinary revenue growth. Many non-financials leveraged up as well, borrowing for share repurchases, thereby spreading the same profits over fewer shares, making earnings per share look a lot better.

In this recovery, it will be harder to use financial leverage to increase profitability. Those companies that can improve ROE without increasing financial leverage should command a premium valuation.

BEST RALLY IN DECADES

European stock markets have rallied strongly. From multi-year lows on March 9 to the recent peak on May 20, the broad European market rose by one-third, the steepest rally in the last 35 years.

The first shoots of economic recovery have emerged on the continent, tempering what was otherwise a gloomy outlook. Lower interest rates, and a raft of fiscal stimulus measures have ushered liquidity back into the market.

Governments have intervened to prop up the banking and auto industries. Investor sentiment turned a corner; instead of reacting badly to bad news, investors shrugged it off, figuring that better news is ahead of them.

As a result of these factors, investors reassessed the survivability prospects for companies that had previously appeared to be headed for bankruptcy. The market's headline gain masks aggressive sector and style rotation, which has led to a wide disparity between the top performers and the laggards.

The bank and insurance sectors rose by 106% and 72%, respectively, while returns on telecom and health care stocks were a paltry 8% and 9%, respectively. Seventeen of the 20 largest gainers during this period were financials, while the mid-cap stocks significantly outperformed large-cap stocks.

Current valuations suggest to us that much of the upside in the riskier stocks may already have been booked: The European bank sector's price/earnings ratio has risen to 15.3 times consensus 2009 earnings expectations, up from just 5.4 in March. Similarly, the technology sector is up to 19.5 P/E from 12.3, and the consumer discretionary sector is at 19.1, up from 11.2.

LAGGARDS LOOK BETTER

Valuations in the March-to-May laggards look increasingly attractive. The European telecom sector now trades on a 2009 P/E of less than 9. The pharmaceutical stocks, which are now only 10 times this year's earnings, also appear cheap.

In terms of size, mid caps have outperformed large caps and currently stand at a record relative high. In Europe, our preference for large caps comes from their exposure to developing economies, which we believe will lead global markets higher, rather than the small-cap and mid-cap segments, which are more domestically focused.

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This commentary was first published in the June issue of 'The View', by Citi Private Bank. Marshall Kaplan is a Senior Equity Strategist Private Client Investment Strategy Citi while William Mann is the European Equity Strategist for Private Client Investment Strategy Citi