The Q4’11 earnings season is over and U.S. inflation data for February were released last week. It is time to revisit the Rule of 20 and assess the outlook for equities.

As a reminder, I turned positive again on November 17, 2011 (TIME TO INCREASE EQUITY EXPOSURE) at 1221 on the S&P 500 Index which was then selling at 12.9x trailing EPS with inflation at +3.5% YoY for October.

Under the Rule of 20, the appropriate PE should be 16.5 (20 – 3.5) which, using $94.75 trailing EPS gives a fair value of 1563 for the S&P 500 Index. As the chart shows, the current 22% undervaluation is very rare and has been a strong buying signal.

Now that US recession risks have significantly diminished and that inflation seems to be receding, both earnings and valuation risks have decreased meaningfully.

Of course, risks remain, particularly from the political side. This is why valuation is so attractive. However, the Euro risk has entered its “terminal” phase and while US politicians continue to act … as mere politicians, the resiliency of the economy and the easing of inflation, coupled with extraordinarily low interest rates promised for “an extended period” and ample liquidity, provide a good background for US equities.

Five months later:

• The S&P 500 Index is at 1400, up 14.9%.
• Trailing earnings are up 1.7% to $96.42.
• Inflation has decelerated to 2.9%

Based on these factual parameters, the Rule of 20 says that fair value for the S&P 500 Index is 1650 (17.1 x $96.42), nearly 18% above current levels, somewhat less undervalued than last November but nonetheless pretty attractive.

On March 5, I discussed the potholes on the road toward fair value (U.S. EQUITIES: NERVOUS GREEN LIGHT!), highlighting all of the well known problems in the world but focusing on the most important factor: earnings (see also U.S. EARNINGS: TAIL WIND TURNING?) :

Yet, to me, the biggest risk lies with earnings which, ex-Apple, have declined 9.7% QoQ  in Q4. This is a pretty big event since first quarterly declines exceeding 8% have happened only 4 times since 1988. On the other hand, a second consecutive quarterly decline only happened in Q3 2007. Not much of a trend setter, but -9.7% is indeed a big decline when valuing equities on trailing earnings.

Some facts on earnings:

• profit margins peaked in Q3’11 and declined 85 bps in Q4;
• productivity rose only 0.5% in Q3’11 and 0.2% in Q4’11 after jumping +6.2% in Q1’10. Unit labor costs were +1.5% in Q4’11. They had declined 0.8% in 2009 and 2.0% in 2010. The offset to rising employment is declining productivity and increasing labor costs.
• the U.S. economy may have avoided the double dip but it remains on slow speed; as Peggy Noonan wrote, “the economy is coming back, at least for now and at least a little;
• Europe is weak any which way we look at it;
• China is slowing and Beijing could be misreading the situation or fail to re-stimulate on time or sufficiently;
• slowing inflation provides little fuel to revenue growth.

My conclusion still holds:

In all, until proven otherwise, investors should now assume that the earnings tail wind for equities has stalled.

Consensus estimates for Q1 EPS have stopped falling and are now $23.79, up from $23.71 two weeks ago and +5.4% YoY. Q2 estimates now stand at $25.91, +4.2% YoY, and appear more at risk than Q1 estimates. Obviously, next earnings season, starting in mid-April, will be watched with trepidation.

Meanwhile, the other parameter in the value equation is behaving reasonably. The U.S. CPI rose 2.9% YoY in February and appears set to stay below 3% for a few more months.

• Monthly inflation was 0.4% in February. Even if it continues at that rapid pace through May, the YoY increase will remain below 3% since monthly inflation averaged 0.4% between March and May 2011.
• Core CPI has been rising between 0.1% and 0.2% MoM for 9 months running (0.1% in February), indicating little inflationary pressures outside of food and energy. If it continues at that pace, core inflation will remain at 2% or less through May.
• Food at home inflation peaked at 6.3% YoY last October. Since then, monthly increases totaled only 0.2%. Food prices jumped 1.0% MoM in March 2011 and another 0.9% in the following 2 months. If they remain stable in coming months, the YoY increase will decline below 3%, somewhat offsetting the increase in energy prices.

In all, the Rule of 20 fair value for the S&P 500 Index is likely to remain stable around the 1650 level for the next several months.

This is the first time since August 2011 that the Rule of 20 fair value is stabilizing (see with line in chart below). The last time the Rule of 20 fair value stopped rising was between November 2010 and July 2011 as inflation accelerated from 1.1% to 3.8%. This 270 basis points rise in inflation shaved 13.5% off the fair PE (2.7/20) more than offsetting the 10% gain in trailing EPS during the same period.

U.S. equities were 26% below fair value in November 2010 but as they rose 12.8% while fair value declined under the pressure of rising inflation, the undervaluation dropped below 10% in April 2011 which triggered my March 29, 2011 warning US EQUITIES: APRIL PEAK?.

RISK/REWARD ANALYSIS

The numerous problems in the world are well documented by economists and strategists, especially those of the bear types. There are admittedly fewer of these ursids nowadays (THE BULLS ARE BACK, RIGHT ON CUE) in spite of the fact that earnings might be peaking.

The big difference with the current situation compared with last year’s is that the risk is currently centered on earnings while in both 2010 and 2011 rising inflation was the reason for valuations getting less attractive. Changes in inflation rates are more gradual than earnings movements which can, at times, be sudden and violent. Thus, risk is more significant at this point than last year, something which we must integrate into the risk/reward analysis.

The S&P 500 Index 200 day moving average currently stands at 1263, indicating a 10% downside to this important trend line. It is rising but at a snail’s pace. More fundamentally, a return to a 25-30% undervaluation like in 2010 and 2011 would set the S&P 500 back to the 1150-1240 range, 12-18% below current levels, declines similar to those of the previous two springs.

The 18% upside to fair value remains superior to the downside but not much. A more balanced risk/reward equation would be reached near the 1450 level, only 3.3% above current the current level.

Of course, the above analysis assumes normal odds of getting back to fair value as defined by the Rule of 20. The last time we reached fair value was in December 2009 (US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!). In 2011, we got only within 9% of fair value as oil and Europe made things pretty complicated for investors.

This time around, there is oil, Iran, Europe, China, the U.S. fiscal cliff, elections in Greece, France and the USA. And, of course, EARNINGS! Investors are much more susceptible to adverse macro events when the risk/reward ratio is not compelling.

Many commentators are reminding investors of the fact that equities peaked in the spring of both 2010 and 2011. So the next 8 weeks will be challenging because everyone, all mindful of left tail risk and knowing everyone might want to “sell in May and go away”, might want to get ahead of the pack and sell in April.

In 8 weeks, Q1 earnings season will be almost over. Let’s see how it goes. Meanwhile, assess your equity exposure, manage your risk and watch the technicals.

The S&P 500 Index has more than doubled in the last three years in what has been an extraordinarily unpopular market recovery. Thanks to the internet, particularly to the blogosphere, everybody is now able to express and discuss his opinions and make them widely available. Since 2008, the bears have been a constant feature in the media, their views being happily megaphoned throughout the web and in the conventional media. Given that the last decade bred large herds of understandably angry bears (see BUT, WHO’S THE PIPER?), they have occupied the scene probably like never before.

As equity markets were recovering, bulls remained generally subdued while increasingly frustrated bears got more and more vocal about everything negative throughout the world which, suitably, never stopped providing them with highly fertile feeding grounds.

Now that equities have bounced back 20% from their October 2011 low and that the U.S. double dip scenario is losing popularity, it seems that fewer people are trying to stop the bull. The media are more open to positive views on the stock market. This week’s Barron’s carries a front page article Enter the Bull while the FT is somewhat more prudent with its The bulls return, but for how long?

Even Alan Abelson is trying to sound bullish:

And we don’t think last week will necessarily translate into fini for the advance. Rather, we suspect animal spirits had gotten a bit out of hand. (…) On that score, we found more than a tad discomforting the very buoyancy of the market, as investors espying what they took to be a significant bullish move began, hesitantly at first, then more and more assertively, to take the plunge. The sentiment figures of both pros and individuals present unmistakable evidence of swiftly gathering enthusiasm.

Michael Santoli, after spending most of his Barron’s column suggesting that the market is eerily resembling 2011, ends with a wishy-washy, say-it-all, but nevertheless seemingly optimistic series of words

The evidence, then, points to a correction, but higher prices likely will follow. Absent one of those nasty shocks we’ve almost come to expect, the market can weather any near-term setback well.

Nouriel Roubini also turned bullish last week (see the EQUITIES section of Feb. 8, 2012 NEW$ & VIEW$). Nomura Securities discarded the proverbial Japanese politeness when it published the following chart in their market comment last week. Among their “Six Reasons To Worry”, the first one listed was the news that Roubini has turned bullish (chart via Brazilian Bubble).

Last Friday, Chart of the Day came up with a chart supporting the increasingly popular idea that this “rally has legs”:

To provide some perspective to the current Dow rally that began back in early October 2011, all major market rallies of the last 111 years are plotted on today’s chart. Each dot represents a major stock market rally as measured by the Dow. As today’s chart illustrates, the Dow has begun a major rally 28 times over the past 111 years which equates to an average of one rally every four years. Also, most major rallies (78%) resulted in a gain of between 30% and 150% (29.8% to 150.5% to be exact) and lasted between 200 and 800 trading days (9.5 months to 3.2 years) — highlighted in today’s chart with a light blue shaded box. As it stands right now, the current Dow rally (hollow blue dot labeled you are here) would be classified as well below average in both duration and magnitude.

WHERE’S THE MEAT?

Interestingly, the new bulls’ vocabulary makes little use of words like earnings or valuation. The leading Barron’s article cited above has but a small paragraph on potential earnings growth in 2012-13 and the resulting “reasonable” P/E ratios. The FT’s piece has a single phrase about the apparent low P/E, concentrating on the “improving” economic situation and technical and historical considerations. History is the backbone of Barron’s story as it draws on Wharton School finance professor Jeremy Siegel’s research on the past 141 years of equity performance

from which a fairly straightforward cyclical pattern can be discerned: a strong tendency for periods of worse-than-average returns to be followed by periods of better-than-average, and vice versa. Since the past five years have been squarely in the worse-than-average category, better-than-average returns in the two-year period just begun are now likely.

The bulls of 2009 must be wondering why this “fairly straightforward cyclical pattern” could not be so readily discerned 3 years ago and how the 102% return of the past 3 years fit within the expected “better-than-average returns in the two-year period just begun”.

I have always been amazed by the fact that so many people writing about equities, be them journalists, economists but even strategists or equity analysts, can write long essays, delving on economic, political, technical and historical matters without spending much time on earnings and how much these earnings can be worth.

Earnings are the lifeblood of equities. Earnings multiples are the value amplifiers of said earnings. Prudent investors should focus on trailing earnings, which necessitate little research efforts and limited economic input. They should also endeavor to understand the behavior of P/E multiples in order to constantly monitor the risk/reward ratio. These two tasks being completed, THEN one can take the time to figure out which way the economic, political, technical and historical winds are blowing in order to complete the risk/reward analysis and take appropriate investment actions in accordance with one’s particular investor profile.

THE NEW BULLS ARE VERY WELCOME

We should not ridicule the new bulls. First, we sure need them at this stage. Second, there is always a chance that they be right, even though many economists and analysts succeed in making a lifelong business by being generally wrong.

Earnings are peaking. With 82% of companies having reported so far, Q4’11 EPS are 5.3% lower than Q3, the first quarterly decline since Q3’07.

Trailing 4Q EPS should reach $96.65 after Q4 earnings are all in, a mere 2.1% above their level after Q3’11. If analysts are right on their $24.00 Q1’12 estimate, trailing EPS will only be up 1.5% during the next 3 months.

The significance of the earnings slowdown is easily understood when one considers that trailing earnings have increased 125% since March 2009, coincident with the 103% equity recovery during the same period. Trailing earnings troughed in Q3 2009 but quarterly EPS bottomed in Q4’08, just before equity prices troughed in March 2009.

Trailing earnings have gained 15% during 2011. This tail wind for equity markets has almost disappeared, just as the new bulls are arriving with their market forecasts deprived of much earnings analysis. True, analysts continue to see earnings rise, their Q4’12 estimate being $28.21, up 17.8% YoY. But they may be overseeing these facts:

• profit margins are at an all-time high and appear to have peaked out;
• productivity rose only 0.5% in Q3’11 and 0.2% in Q4’11 after reaching +6.2% in Q1’10. Unit labor costs were +1.5% in Q4’11. They had declined 0.8% in 2009 and 2.0% in 2010. The offset to rising employment is declining productivity and increasing labor costs.
• the U.S. economy may have avoided the double dip but it remains on slow speed;
• Europe is weak any which way we look at it;
• China is slowing and Beijing could be misreading the situation or fail to re-stimulate on time or sufficiently;
• inflation is also slowing, providing little fuel to revenue growth.

All this to say that trailing earnings have ceased to be supportive to equity markets unless the economy gets surprisingly stronger and/or inflation accelerates. In addition, analysts appear to be on the optimistic side for the rest of 2012 and investors should be prepared for negative earnings revisions in coming months, never a positive.

MULTIPLE PROBLEMS

The new bulls are thus dependent on rising P/E ratios for their better mood to prove justified. At its current 1350 level, the S&P 500 Index is selling at 14x trailing EPS, only 7% below its historical 15x median. However, the more dependable Rule of 20, which takes inflation into account, says that the fair P/E should be 17x with inflation at 3%, setting fair value at 1643, +22% above current levels.

The problem is that trends in P/E ratios are much more difficult to foresee than earnings, especially trailing earnings! Obviously, positive economic, political and technical backgrounds would greatly help lift investor sentiment which would normally translate into rising earnings multiples. Here’s my reading on sentiment:

• the Citigroup Economic Surprise Index has reached its historical high level and has been moving sideways since December 2011. The best we can hope is that the economy stays good enough to meet already more upbeat economists forecasts;
• Europe is unlikely to provide much good news in coming months. In fact, the Eurozone 2012 political landscape looks pretty dangerous (see THE COMING “EURO SPRING”);
• Needless to say, the U.S. political scene provides little hope for anything uplifting for a considerable while.

The new bulls are thus certainly welcome even if they speak more technically than fundamentally. Given the state of the world, help is needed from all corners.

STUFFING THE BULLS

Fortunately, Big Ben is towering on financial markets. His QEs of all denominations, what Don Coxe calls “the Fed’s financial heroin”, are keeping interest rates, short and long, low enough and liquidity high enough to stuff even a nervous bull. Most other central bankers are also stuffing the grizzly, even the generally reserved ECB whose new Italian skipper is proving more German in his talk than in his walk.

As importantly, inflation may be slowing even more. The Rule of 20 states that fair P/E is 20 minus inflation. If U.S. inflation falls to 2.0% YoY, fair P/E would rise to 18x, providing another 6% upside potential.

THE RULE OF 20 IN ACTION

The current 22% undervaluation of equity markets is rather exceptional. Since 1956, there have been only 9 periods of 20%+ undervaluation under the Rule of 20. Four of these instances have lasted more than 6-9 months. In all cases but 2, equities rose strongly afterward.

The two periods when equities needed time (years) before roaring back to life were 1956-58 and 1976-78, two periods marked with accelerating inflation. Even during 1982-86, when deep undervaluation remained extreme, equity prices rose strongly from 107 in July 1982 to 242 in December 1986. Earnings rose only 27% from 1982 to 1986 but inflation dropped from 8% to 1%. Under the Rule of 20, such a drop in inflation, by itself, increases fair value of equities by 60%.

Stocks got carried away during 1987 even though earnings flattened and inflation accelerated. The Rule of 20 fair value was reached in early in 1987 at 290 on the S&P 500 Index which reached 16% overvaluation in August at 330. Post the October crash, the Rule of 20 flagged undervaluation of 13% which subsequently rose to 21% one year later as earnings shut up 33% and inflation stayed unchanged at around 4%. Meanwhile, the S&P 500 Index gained 19%.

ENTERING THE EUROZONE

Equities are not cheap for no reason. Investors have plenty to worry about which generally brings good investment opportunities. The old contrarian saw

Buy at the sound of cannons,

Sell at the sound of violins.

 

is often very useful when things get murky and complicated. Currently, the cannons are roaring in Europe. The problem there is that the uncertainty level on Europe is, like the debt level, extreme and global banks are right in the middle of the battlefield. Markets would no doubt get very nervous on the outcome of a Eurozone breakup, the probability of which is far from negligible at this point.

Unless the U.S. economy starts weakening again, equity markets will likely trend up but remain highly nervous and dependant on Europe.

The bulls are back, but as people of Pampelona know, it’s better not to be totally in front of the herd, unless one runs very very fast…