The price-to-peak earnings multiple contracted slightly to 12.1x last week.  On Friday, the stock market concluded a choppy week in which a steady flow of third quarter earnings reports surprised to the upside.  The earnings results thus far have been much better than analysts expected with blow out reports from tech bellwethers Amazon (AMZN), Apple (AAPL), and Microsoft (MSFT).  Financial stocks presented a mixed bag as earnings were less likely to beat expectations, but were still better than expected for the most part.  Even though most stocks are still topping analysts' profit forecasts, market sentiment seems less accommodating than it has been in the last few quarters.  It is no longer quite enough to beat on the bottom line-investors are looking for top line improvement (revenues) and that has been far harder to find.

An interesting development occurred last Wednesday following Wells Fargo's (WFC) highly anticipated earnings announcement.  Well known analyst Dick Bove of Rochdale Securities appeared on business television just after the results were released and seemed optimistic about the banks strong performance in the quarter.  After all, the bank was able to report a record profit of $3.24 billion and its acquisition of Wachovia looked to be less of a drag than previously anticipated.  Later that day, after Bove had the opportunity to delve further into the intricacies of the report, he downgraded the stock to a sell, which sent WFC and the market solidly lower.  He reversed his opinion on the shares after realizing that $3.6 billion of profit in the quarter was the result of what amounts to a hedging transaction from the Wachovia acquisition, the removal of which would made the bank's results look much less solid.  Furthermore, if Wells Fargo is really running on all cylinders right now why are they not ready to pay back TARP funds?  These concerns, masked by the record profits, are certainly legitimate.  Not surprisingly, after his major reversal Dick Bove, vowed that he will never again give his opinion on a stock without having enough time to fully understand the results.

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The percentage of NYSE stocks selling above their 30-week moving average has declined to 87% this week.  Our sentiment indicator ticked down in the last week to the lowest level in the last three months.  We would expect some normalization in this metric

over the next couple of weeks as the moving averages are headed higher.  Besides the statistical reason for the normalization, we also expect that overall investor sentiment will start to lower to more historically normal levels.  We have observed a rapid rise in risk tolerance since the market's nadir, but the market's recent reaction to stronger than expected fundamentals shows that investors have become harder to please.

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From the perspective of a value investor, we think the current market environment favors a defensive asset allocation.  This liquidity driven market could still head higher in the coming weeks, but on an average return basis, extremely high investor sentiment and unattractive market valuation is not the best environment in which to deploy more resources to risk assets.  With that being said, there are undervalued stocks in almost any market condition, and right now the high quality blue chips look most attractive.  This rally has been seen the biggest returns generated by some of the riskiest stocks, but that trend may well have played itself out.  We expect a shift back to higher quality, lower risk stocks as part of a maturing market cycle.