If you have played the market rally since last March, you have involved yourself in what perennial bears called the biggest sucker rally in history. Well, happy suckers, you should now start ducking!

After a 65% jump in the S&P; 500 Index, while trailing operating eps declined another 13%, all PE charts on 12-month trailing earnings are screaming “Sell !!”

  • The conventional PE ratio is 27.7x operating eps, up from 15.6x at the end of February 2009;
  • The PE10 cyclical ratio, beloved by bears last spring, is now 18x, up from 12x last February.
  • Doug Short’s chart of the inflation-adjusted PE10 ratio is now 20x, up from 13.4x


More importantly, the Rule of 20 PE (see S&P 500 Index PEs at Through: A Detailed 80 Year Analysis) which gave a strong buy signal at 16x last March, is currently high at nearly 28x when a fair PE should be 18-20x given current inflation rates.


However, the severity and suddenness of the economic downturn at the end of 2008 was such that S&P; 500 operating earnings went negative in Q4-2008, evaporating from almost $16.00 in Q3. But corporations quickly adjusted their costs and operating profits recovered to the $10 level in Q1-2009, $14 in Q2 and $16 in Q3.

It would therefore be simply wrong to disregard the fact that 12-month trailing eps are meaningfully reduced by the Q4-08 $0.09 loss, especially since corporate America has successfully reacted to the dire economic conditions.

There are 3 ways to normalize eps without making a 2010 earnings forecast:

  1. normalize Q4-08 eps from the $0.09 loss to, say, $5.00 (the mid-point between Q4-08 and Q1-09). Current trailing eps would thus be about $45.
  2. Annualize the last 9 months. Trailing eps would be $53.
  3. Annualize Q3-09: eps would be $63.

“Trailing” PEs thus decline to 24x, 21.8x and 17.5x respectively which, using the conventional PE approach, says that equities are overvalued by 17-60%.

Under the Rule of 20 (fair PE = 20 minus inflation), using 2.0% inflation as per the core CPI (last 6 months annualized), the S&P; 500 Index is at best 2-3% below fair value (17.5 + 2.0 = 19.5). At worst, it is 30% overvalued (24 + 2.0 = 26).

This is the first time since March 2009 that the Rule of 20 gives such downside against so little upside. In August, when the S&P; 500 was 1026 I wrote:

If current estimates prove accurate, equity markets have room to advance 17-25% to 1120-1280, before they reflect fair value on these numbers.

In August, estimates were for annualized eps of $60 and $64 for Q3 and Q4 2009. Q3 came in at $63 while current Q4 estimates are $67.

Based on Q4-2009 estimates, the Rule of 20 PE is 18.4 (16.4 + 2.0), 8% below fair value (S&P; 500 = 1200.) While still reasonably attractive, the margin of safety has narrowed significantly.

Given the fragility of the economy, of the banking system (housing and CRE remain dangerous), of the US dollar and the US budget deficit, equity markets that are merely fairly valued are not particularly attractive.

It is important to note here that core CPI has accelerated from 1.5% (4 months annualized) last August to the current 2.1%, shaving 3% off fair value. Trends in core inflation need to be monitored closely here.


Under the current very difficult economic conditions, corporate America has been able, thanks to unprecedented layoffs, extremely low interest rates, a weak dollar and big declines in non-wage expenses, to restore its quarterly earnings to levels that are only 25% below their 2006-2007 average level.(Nominal GDP chart from Econompicdata)

Current S&P; 500 Index consensus estimates for 2010 are $75 (according to S&P;) with quarterly levels rising from $66 annualized in Q1 to $82.30 in Q4-2010. This would be a very steep 24% rise in but 4 quarters. If so, eps one year hence would be only 3% lower than the 2006-07 average quarterly level. My sense is that it is premature to display such optimism.

image This RBC Capital Markets’ eps revision index chart supports the notion that excess optimism is creeping in.

Macro earnings models are no doubt positively influenced by the unprecedented jump in productivity during this cycle. US corporations have been extremely swift in reducing labor costs during the down cycle. Labor costs fell at a 5.2% annual rate in Q3 after dropping 6.1% in Q2, capping the biggest 12-month drop since records began in 1948.

But many obstacles remain as costs can only be shaved up to a point:

  • Top line growth remains very weak. As David Rosenberg writes:

image Gross value added in the non-financial corporate business sector, which is a proxy for nominal sales, fell 0.4% in Q3 and is negative now for four quarters in a row. The YoY trend in this GDP sales proxy is now -5.6%, compared with -4.3% in Q2, -3.3% in Q1, and -1.4% in Q4 of last year.

  • Labor costs will no doubt rise as the economy keeps recovering.
    alt=”image” align=”right” src=”″ /> In fact, we can argue that labor costs MUST rise if we are to have a recovery since labor costs are also labor income, the main feed to personal income, itself the main feed to personal expenditures.
  • Corporate profit margins will have difficulty avoiding compression as labor costs rise (through higher wages, hours worked and/or employment). Core PPI has been slowing down rapidly throughout 2009 indicating increasing difficulty for corporations to raise prices in both the goods and services markets.



  • Non-wage expenses fell at a 6.7% annual rate in Q3 owing to a lower tax bill, lower depreciation expense and lower interest costs. Difficult to expect a repeat of these in a rising economy.

Finally, are earnings really as good as perceived when only looking at S&P; 500 companies? David Rosenberg analyzed recent corporate profits from the national accounts. Profits surged $123 billion in Q3 from Q2.

Interestingly, $97 billion of that $123 billion profit increase came out of the financial sector — so one area (with a 25% share) accounted for about 80% of the pickup. Very skewed performance. (…) Profits from non-financials barely rose at all in Q3 — up 0.6%, which was actually the second worst showing in the past six quarters (from +2% in Q2 and +2.9% in Q1 — not annualized). At an annual rate, that is a 2.3% gain — not much to write home about, and still down 6% from last year’s recession levels.

Much is being made of the profits that are now being derived from the stronger global (mainly the BRIC countries) economies (though for the total profit pie — not just the S&P; 500 — the overseas operations only make up 20%). Indeed, earnings derived from global operations did rebound 6.7% (29% annualized) after three down quarters in a row, and still down 19% on a YoY basis.

In total, profits are up 20% from their worst levels. Outside of the snapback in the financials, which received tremendous life support from the government, profits are up less than 7% from the lows.

We know that banks have strongly benefitted from huge interest rate spreads owing to the very favorable yield curve while “delaying” booking losses from their deteriorating housing and CRE loan books.

For all these reasons, I would be particularly cautious in using 2010 estimates at this point as there definitely seems to be a fair bit of optimism.

In conclusion, US equities are fairly valued using annualized Q3-2009 eps and 2% inflation. They could rise another 8% to 1200 (S&P; 500) if Q4-2009 reach the expected $67 level but the risk/reward ratio has become unfavorable for the first time since March. The risk is accentuated by the fact that estimates for 2010 appear to display excess optimism given current economic conditions.



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