Equity valuation is simply profits times the PE ratio. The profits side is reasonably easy to deal with, especially if one uses trailing earnings.
The PE ratio can be more subjective. What is essentially a discount factor can get tricky if one tries to gauge greed and fear into the equation.
The Rule of 20 PE Ratio aims at simplicity: US equities have historically traded around a central value of 20 times trailing EPS minus the inflation rate. (For a complete discussion of The Rule of 20, see my March 7, 2009 analysis S&P 500 Valuation Analysis: Near Bottom and S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS).
I have designed a barometer that graphically indicates where US equities stand within the The Rule of 20 overvalued/undervalued range of possibilities.
At its current 1090 level, the S&P 500 Index PE ratio is selling at 16.5x actual trailing EPS of $66.12. When Q2 earnings get incorporated, trailing EPS will likely jump to the $71-72 level. On this basis, US equities are selling at 15.2x EPS. The Rule of 20 states that fair PE should be 18 using the current but likely high 2.0% inflation rate. Equities are thus currently 9-16% undervalued depending on whether one uses current trailing EPS or “normalized trailing EPS” using Q2 2010 estimates.
Using 1.0% inflation, fair value would rise another 5% but such a low inflation rate may be too low for comfort unless monthly core inflation strengthens. Investors may well become concerned that profits will soon be reduced by falling prices.
This barometer chart must be read in conjunction with 2 other charts: earnings trends and inflation trends to better assess equities risk/reward equation. For those wondering about the normalization of 2009-10 data, it is explained in many of my previous Valuation Watch posts, initially and particularly in S&P 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS .
Earnings are presently in a strong uptrend. Q1 2010 EPS were $19.37, 12.9% above estimates. Q2 estimates have been raised 3.5% from their March 2010 level to $19.64, essentially flat from their Q1 level. This would bring trailing EPS from $66.12 currently to $71.95 since Q2 2009 EPS were $13.81.
RBC Capital Markets Strategy Team:
Top-line growth has started to come through alongside the broad recovery in nominal GDP. At the same time, costs remain well contained. Wage and salary disbursements in the private sector have expanded by only 0.8% over the past year, with growth likely to remain at the low end of its 60-year range given ongoing
slack in the labor market.
On a related point, earnings estimate revisions usually peak coincident with a crest in leading economic indicators. We have also found that analysts are most likely to overestimate prospective earnings growth as economic momentum passes its apex. It is usually right at this juncture where equity price turbulence emerges as analysts (and investors) begin to recalibrate their growth projections. The performance period following the January/February 2004 peak in leading indicators offers
a recent example of just such a dynamic. This was when the equity market turned somewhat volatile for 6-9 months before finding a more stable footing.
Obviously, the European crisis will slow these economies down while the lower Euro will create competitive pressures for world exporters. Since about 35% of S&P 500 Index companies revenues are sourced from abroad, the headwind against EPS is already being felt: analysts have not raised 2010 estimates very much considering the big Q1 surprises.
US inflation is very important for the Rule of 20 since it directly and materially impacts the multiple (20 minus inflation). The April CPI was down 0.1% from March but up 2.2% YoY. However, total CPI is up at a 0.6% annual rate year-to-date and 1.2% over the last 6 months. Higher inflation is clearly not a major risk at this time.
In fact, deflation is a more significant threat. Core inflation is up only 0.1% since last November, being unchanged for the last 2 months. Core CPI is up 0.9% YoY in May, the lowest annual rate recorded since the 1960s.
As BCA Research points out
Of the three major components of core CPI, shelter is already in deflationary territory, while goods price inflation has finally rolled over decisively. Services sector inflation remains near the bottom end of its multi-year range.
The output gap remains wide and there are virtually no signs of pricing pressure at the retail level. In fact, major retailers such as Walmart have recently announced further price slashing, citing customers’ precarious financial positions. Employment growth has recently turned positive, but the unemployment rate is still very high. Consumers will likely remain very price-conscious for some time. This environment underscores that there will be considerable disinflationary pressure and outright deflation in the core CPI index should not be ruled out.
Greed and Fear
In late May the put/call ratio reached 1.53, which is more than three standard deviations above normal. The proportion of stocks below their 50 DMA is back to a March 2009 level. Meanwhile, the AAII bull/bear spread is at 31.9%, only finding lower lows during the
early-1990s recession/S&L crisis, the January 2008 mono-line insurers meltdown and the March 2009 lows.
Lastly, the other headwind comes from the seasonality of equity market. “Sell in May and go away” seems to be in action, although, historically, the most dangerous months are September and October.