US EQUITY OUTLOOK: STILL POSITIVE

My last market analysis (US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!) was on December 8, 2009 when the S&P 500 Index was 1100.

The Index has been hovering around that level (+/- 5%) since then even though quarterly operating earnings have grown 10% QoQ,  beating estimates and triggering continued positive earnings revisions. Nearly 75% of S&P 500 companies beat estimates in Q4 and more than half beat revenue expectations as revenue growth reached 7%. Corporate earnings guidance has also been positive.

Consensus estimates are now $78 for 2010 (up 4% since November 2009) with quarterly eps rising from $17.37 in Q409 (annualized rate of $69.48) to $21.44 in Q410 (annualized rate of $85.76).

Current trailing eps of $57 remain constrained by very poor earnings 4 quarters ago. S&P 500 Q409 earnings are $7.26 higher (72%) than Q109, meaningfully boosting equity valuation for investors who blindly use trailing earnings without looking at the details.

The truth is that corporate America was very quick to react to the Q4 2008 extraordinary shock which brought quarterly S&P 500 earnings from $16 in Q308 to its first loss since the early 1980’s in Q408.

image While I generally prefer to use trailing earnings, this cycle required quick recognition that, without some earnings normalization, valuation levels were artificially high.

I think that Q409 annualized eps levels of $69.48 are appropriate to assess equity market valuation at the present time. On this basis, absolute PEs are 16.8x (S&P 500 = 1170), some 12% above the unscientific 15 magic level.

However, the more robust Rule of 20 approach says that fair PE is 18.0-18.5x assuming total-CPI inflation stays around 1.5-2.0%. On that basis, the S&P 500 Index remains 7-10% undervalued. Fair index levels under current inflation rates are 1260-1300.

EARNINGS OUTLOOK

S&P 500 companies quarterly earnings are back to Q2 2008 levels, having risen steadily from their Q4 2009 abyss in spite of still difficult economic conditions.

So far, the story has been one of cost cutting but revenues have finally shown some positive signs in Q4 2009.

image Top line growth should continue to improve in 2010 as the ongoing imagerestocking cycle gradually leads to rising employment and consumer demand. Many indicators are pointing to positive employment numbers pretty soon while retail sales data have shown encouraging signs lately.

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The earnings background is thus good enough to feel comfortable using Q4 2009 annualized earnings as normalized trailing earnings of $70 for the purpose of valuing equity markets, keeping in mind that 2010 consensus is $78.

BUT SHOULD WE USE NORMALIZED EARNINGS?

In early March 2009, in S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS, I strongly argued against the blind and lazy use of then depressed trailing earnings to value equity markets. At that time, reported earnings greatly suffered from the HUGE and extraordinary losses incurred but a few financial companies such as AIG which had little weight in the S&P 500 Index but a disproportionate negative impact on the Index earnings.

I explained that these extreme losses would have a negative impact on the Index earnings until Q4 2009. Over that 12-month period, quarterly Index earnings went from -$0.09 to $17.37. That jump is only partly explained by corporate America cutting costs. A significant part of the rise is due to the computation method for Index earnings and the composition of the Index itself. For an explanation of earnings computation pitfalls, read the section titled THE CURRENT PROBLEM WITH HUGE LOSSES, OPERATING OR REPORTED in my above noted post.

As to the impact of index composition, suffice to say that many of the companies with HUGE losses one year ago (e.g. AIG, GM) are no longer part of the Index but their HUGE losses continue to weigh on Index trailing earnings.

What “purists” also forget is that company valuations generally do not evaporate when earnings collapse, let alone a whole country market.

It is in extreme periods like 2008-09 that investors must do a bit more work and use common sense and rationality. Rigidly sticking to dogma can result in missed opportunities…

Normalizing current earnings to asses equity market valuation is still justified for reasons explained in the EARNINGS OUTLOOK section above. Q1 and Q2 2009 earnings continue to pull trailing earnings below current earnings power as measured by the most 2 recent quarters, which total earnings are 38% above the preceding 2 quarters. Admittedly, the impact is not as severe as during most of 2009 and greater caution must be exercised from now on.

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Related post: US EARNINGS OUTLOOK

 

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