This quarter again, S&P 500 earnings are coming in above consensus with a beat ratio around 80%. Q2 EPS should easily exceed $20.00, 45% above last year’s $13.81 level.

This would bring trailing 12 months EPS above $73, more than 10% better than the TTM EPS after Q1, when the S&P 500 Index was around 1200, 10% higher than currently. This is a 20% decline in valuation in less than 3 months!

Fears of a double dip combined with the sovereign debt crisis in Europe right when equity markets were near fair value on the Rule of 20 basis triggered a good correction which has brought equities back in the undervalued territory.


US equities, as measured by the S&P 500 Index are currently 18% undervalued under The Rule of 20 (fair PE = 20 minus CPI). The last time there was such an undervaluation, other than in early 2009, was in August 1988 when the S&P 500 Index reached an undervaluation of 21%. One year later and 10% higher, the Index was near full value after Index EPS had risen 12%.

By itself, undervaluation should not trigger indiscriminate buying. Cheap equities can get even cheaper. But the combination of cheap equities with rising earnings and stable or declining inflation is a strong incentive to buy.

S&P 500 trailing earnings are almost guaranteed to rise another 7% during the next 3 months, even if Q3 earnings remain flat with Q2 levels. That is because Q3 2009 EPS of $15.78 will be swapped for Q3 2010 EPS likely north of $20 (current estimates are $20.72).

This means that by November 2010, TTM EPS will be $78. On that basis, and without using forward earnings, equities are currently selling at 14x EPS. With inflation in the 1.0-1.5% range, The Rule of 20 fair PE is 18.5-19, implying a 25% undervaluation.

Clearly, it would not take much positive economic news for investors to shed some of their current (justified) fears and bid stocks up to close this large undervaluation at a time when interest rates are near zero.


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