Exactly two years ago (see my record), I shed my bear fur amid almost unanimous gloom and doom. Now that the bull ranks are growing, it may be wise to have it handy. Fashion can be fickle …

After the most unpopular doubling in equity prices in history, bears are finally coming out of hibernation realizing that fashion, under the apparent influence of Ben Bernanke’s magical QE2 frock, has evolved from bear fur to bull skin. Whether this is real or artificial overcoat, or even smartly inflated rawhide, remains subject to much debate among the academic community, but it has again become socially acceptable, if not desirable, to have a positive views of equities.

Why have the bears been so wrong?

  • Profits have strongly recovered. The S&P 500 quarterly EPS went from $-0.09 in Q4 2008 to $21.94 in Q4 2010, a mere 9% below the all-time high ($24.06) reached in Q2 2007. US corporate productivity has once again prevailed over weak economic growth.
  • Inflation has declined from more than 5% in mid 2008 to 1.6% last January. Core CPI is below 1.0% compared with 2.5% in mid-2008.
  • US interest rates have declined from about 4.0% in mid-2008 to 3.5% on 10-yr Treasuries. T-Bill rates went from 2% to almost zero in the meantime.
  • The Fed and many other central banks flooded the economy with liquidity. This became especially obvious after Bernanke’s Jackson Hole speech in late August 2010 after double dip fears had pulled equities down 17%, jeopardizing Bernanke’s wealth effect strategy. Bond investors got the cue and money migrated into equities as it became obvious that the Fed was going all-out to boost the economy even at the risk of creating inflation down the road.

Bears find it convenient to credit QEs for “artificially” boosting equities but they neglect the fact that, surprise, surprise!, profit growth has been the critical driver of the rally. Even since the August 25, 2010 Jackson Hole speech, after which the S&P 500 Index staged a spectacular 26% advance, trailing EPS have grown 16%.

Of particular interest is the amazing notion that US equity markets might now be “reasonably valued” at 15.6x trailing earnings after having been “overvalued” 12 and 24 months ago when prices were 50% lower! What Nouriel Roubini once called a “sucker rally” sure has changed viewpoints and attitudes, including his own.

In reality, equity investors have enjoyed significantly undervalued markets throughout the last 2 years. Moreover, the factors causing the undervaluation were pretty clear and reasonably safe. This is no longer the case. While equities remain undervalued, valuation risks are creeping up at a rapid pace.

Nouriel Roubini has recently justified his skin mutation on the fact that profits are very strong and that “some (economic) things are going well”.

He is quite right on profits although (1) he is, again, backward looking and (2) using trailing profits, as I generally do, makes this a moot point.

He is also quite right on improved economic “things”, although this is not necessarily bullish. In fact, a meaningfully better economy is one of the developing risks for equity valuation.

For 2 years, the main attraction of US equities, from a risk standpoint, was its low inflation-adjusted PE multiple. The time-tested Rule of 20 stipulates that fair PE is 20 minus inflation. As long as inflation stayed below 2.0% without deflating, fair PE on trailing earnings was 18-19; yet the actual PE remained substantially below fair PE all along, substantially eliminating valuation risk from the investment decision. Given the weak Western economies and the significant slack in resource utilization, inflation risk in the fair PE equation was insignificant.

This has changed.

I did a graphical analysis of inflationary risks in my Feb. 23rd post CORE INFLATION RISING AT THE CORE  which set the picture on core inflation pretty clearly: it is rising just about everywhere in the world. Even in Japan, the land of the rising sun and falling prices, core CPI has turned positive (6-month annualized rate) after 10 years of deflation. In the US, the Cleveland Fed’s work on inflation trends indicate that the underlying trend in core CPI has troughed at 0.6% in early 2010 and is now 1.8% and rising. Most PPI, ISM and other PMI data (manufacturing and non-manufacturing) point to rising core inflation around the globe. China, the source of global deflationary trends for the last decade, has exhausted its own cheap resources and is experiencing rising price pressures throughout its economy. US import prices ex-fuels have increased at nearly 8% annualized in the last 3 months and the weakening US dollar is compounding the problem.

Add the fact that non-core inflation (food and oil) is not only meaningfully curbing discretionary purchasing power around the world, it is also threatening to morph into core as the various supply/demand factors “temporarily” impacting food and energy prices could stick around for a while.

Most economists, including Fed officials, are brushing the risk aside arguing that the output gap and unemployment are too high at this time to worry about inflation. It may be early to worry about a serious inflation bout. However, the investment world is often moving on second derivatives (remember the green shoots).

  1. It is always calm before the storm and things often start slowly but can gather momentum. Look at the US economy: eUnemployment rateven Roubini now sees “things” going well there. Look at US employment: it is now showing much livelier signs. What is to say that the unemployment rate could not decline enough during 2011 to create some wage pressures in some critical areas (like is currently happening in technology). Many factors are in fact suggesting that the US full employment rate is no longer 5.0-5.5% but rather about 6.5-7.5%. The US unemployment rate has dropped from 9.8% in November 2010 to 8.9% last month, the largest decline in over 50 years in spite of still feeble employment creation.
  2. Core inflation does not need to get very high before it begins impacting equity valuation levels. Under the Rule of 20, each 1% change in the inflation number changes fair value by about 5%, not a big deal after a 100% jump in prices, but significant if what we can expect from here is closer to the historical 8-10% norm.
  3. The Rule of 20 has been constructed using total CPI. It does makes sense to use core CPI when total CPI is impacted by a reasonably clearly temporary phenomenon. But it is far from certain that recent jumps in world energy and food prices are only temporary flares. US Treasury yields may be pricing in some permanency in these recent price moves. January’s total CPI was 1.6% vs 1.0% for core but the last 3-month annualized rate was 3.6% vs 1.6% for core CPI. The risk to equity valuation is rising rapidly.




At 1325, the S&P 500 Index PE stands at 15.9x trailing earnings. Investors using the conventional 10-20x PE range have already crossed the 15x median PE slightly into overvaluation territory. These investors may be concerned about rising inflation, but they have no objective tool to adjust their assessment of “fair” PE. The Rule of 20 provides such a tool, enabling disciplined investors to adjust their portfolio as the risk/reward ratio changes.

As the chart below shows, the Rule of 20, using 2.0% inflation, says that equities are still in attractive valuation area, 12% below fair value at current trailing earnings levels.


But this is a static image while “things” are moving rapidly with many parts in simultaneous flux. The most immediate concern is inflation where the risk balance has suddenly shifted from the downside (deflation) to the upside. Inflation or inflation expectations moving from 2% to 3% in coming months would have two adverse impacts on equity markets:

  1. PE levels would decline at least 5%.
  2. The economic outlook would begin to incorporate monetary policy actions to fight the growing beast. Profit expectations would likely be discounted. Equity investors would be doubtful that faster profit growth could offset the PE discount.

Corporate profits have strongly benefitted from all the stimulus packages and monetary easing around the world since 2009. These have helped restore revenues while costs remained stable or even declined, resulting in a spectacular profit recovery. Trailing earnings, which had collapsed 57% in the 9 quarters between June 2007 and September 2009, took only 5 quarters to recover it all but 9%.

But this great ride is also over.

  • The huge productivity gains enjoyed so far are in line with historical recoveries but, as the WSJ’s Mark Whitehouse clearly demonstrates below, wage rates have not risen in a normal fashion, substantially fattening operating margins in 2009 and 2010:

From mid-2009 through the end of 2010, output per hour at U.S. nonfarm businesses rose 5.2% as companies found ways to squeeze more from their existing workers. But the lion’s share of that gain went to shareholders in the form of record profits, rather than to workers in the form of raises. Hourly wages, adjusted for inflation, rose only 0.3%, according to the Labor Department. In other words, companies shared only 6% of productivity gains with their workers. That compares to 58% since records began in 1947.


  • Briefly stated, the jobless recovery has also been the “marginfull” recovery. But as shown by the charts above, courtesy of Gluskin, Sheff, we have likely exhausted the productivity gains for this cycle. The February employment report confirmed that the private sector is resuming hiring which can only hurt productivity in the next little while. We can also expect wage rates to recover, further squeezing corporate profit margins.
  • I have examined how S&P 500 profits behaved following each of the recoveries in Mark Whitehouse’s above WSJ analysis. Profits continued to grow nicely in 5 of the 8 periods. However, following the 1982-83 recovery, the only other period when wage trends id not follow productivity gains, profits essentially stagnated until the end of 1986.
  • Profit expectations remain quite strong. Estimates are for 2011 profits to grow 15% to $96.19 with Q4 2011 EPS rising 18% YoY. The risk of negative surprises has clearly increased. Costs are rising fast and it is doubtful that revenue growth will accelerate enough to maintain operating margins at their current high level. As investors become increasingly nervous about fiscal and monetary policies in the face of rising inflation, negative earnings surprises would obviously hurt equities.
  • Quarterly EPS have already leveled off recently: quarter over quarter, 2010 profits rose 12.9% in Q1, 7.8% in Q2, 3.1% in Q3 and 1.8% in Q4.


US equities remain undervalued but the gap to fair value has narrowed to 12% (vs 41% in Feb. 2009 and 24% in August 2010) and there is now risk to the inflation assumption in the Rule of 20 equation, as well as potential negative earnings surprises. The “easy” ride is over!

  • Beware of the rising chorus in favor of equities.
  • Do not use estimates in valuing stocks. Rising costs and lower productivity are seldom factored in analyst estimates, especially at turning points.
  • Control your aggregate beta as volatility will increase.
  • Watch inflation trends ( has a nice INFLATION WATCH “spotlight” that provides continuous monitoring of inflation trends).
  • Watch the bond market for inflation expectations. Bond investors spend a lot more time scrutinizing inflation than equity investors do.
  • Do not believe people saying that equities are good in inflationary periods. Central banks will not allow inflation to settle in; the bond vigilantes will not allow central banks to “settle out”.


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