Q3 earnings season begins Thursday.

Standard & Poors data show bottom up EPS estimates for Q3 at $20.71, unchanged from 3 months ago and marginally lower than Q2 actual EPS of $20.90. This would mark the first EPS quarterly decline since December 2008.

If earnings meet current expectations, trailing twelve months EPS would rise to $78.15 by the end of the earnings season in early November, up from the current TTM EPS of $73.22 as Q3 2009 EPS were $15.78.

At 1140, the September close, the S&P 500 is trading at 15.6x TTM EPS and 14.6x prospective TTM EPS after Q3 2010. To many observers, this means that equity markets are fairly valued at around the long-term average PE multiple. This simplistic analysis fails to take into account that inflation is only 1.1% at present, not to mention how low 5-10 years interest rates are. PE multiples, being discounting mechanisms, are directly influenced by interest rates, themselves being also directly influenced by inflation rates. It is therefore imperative to analyze PE multiples in conjunction with inflation rates, which is what “The Rule of 20” does.


The Rule of 20 states that fair PE is 20 minus inflation. The current fair PE is therefore 18.9x trailing eps for a fair value level for the S&P 500 Index of 1384, 21% above current levels. Using prospective TTM EPS after Q3, the fair value level is 1477, 30% higher than currently.

This market remains very cheap. What could go wrong?

  • The double dip scenario remains possible given the dire state of the consumer and the very stretched government finances. I do not buy the “win-win” fantasy that if the economy is strong you get a rising markets on better profits and if the economy is weak you get a rising market through increased government and Fed interventions. A weaker economy would hurt earnings and equities do not enjoy declining earnings very much. Even cheap stocks would get even cheaper before interventions would have any measurable effect.

At this point, however, earnings trends remain positive for equities: the chart below shows that equity markets (dark line) are vulnerable when EPS momentum (red line) turns negative which is not the case just yet.


The next chart plots the S&P 500 Index (black line) with trailing 12 months EPS (red) and the leading economic indicator (dash). Note how equities track earnings (surprise!), which have yet to turn down, but also that the LEI also has not yet turned down.


  • Earnings risk is for 2011. Current bottom up estimates for 2011 are $94.10. Discounting this by 15%, the usual overestimation by street analysts, we get $80, just a touch above prospective EPS after Q3 2010. This is not to say that 2011 EPS could not decline (e.g. lower productivity, health care reform costs, deflation) but the market is certainly not currently trading on the basis of huge earnings gains next year.
  • Deflation is a risk even though Martin Feldstein does not think so. Core CPI is 0.9% YoY in August, 0.6% a.r. in the last 2 imagemonths. Deflation would negatively impact earnings and multiples as was the case in the 1930s. This is the one case where equities might not get much support from valuation. Deflation is a tough beast to tackle and investors uncertainty would get very high in an environment of declining corporate revenues when both the governments and monetary authorities have little ammo left at their disposal. We have seen total inflation around 1.0% many times in the past but core inflation below 1.0% has only been seen in early 1961 in modern  history.

It is true that, as Barron’s reports,

So far, there’s been a surprising lack of positive preannouncements by companies in the S&P 500 – just 34.

Already, more than twice as many companies have warned that third-quarter results will miss analysts’ forecasts. And while the 2.3 ratio of negative to positive preannouncements isn’t far above the historical norm, it’s up sharply from previous quarters.

For the record, the ratio of negative to positive "preannouncements" was 1.1 in the second quarter but only slightly above its historical 2.1 average.

This is why it is prudent to use conservative estimates.  S&P 500 Index stocks sell for 2.1x book value (black line). They sold below 2x during the 1980s when real ROEs (returns on book value) ranged between 8% and 11% vs the current 12.8% (blue line on chart, the green line being nominal ROEs).


These ROEs are achieved in spite of highly underleveraged corporate balance sheets. According to a Bloomberg analysis,

Q2 2010 Cash and Equivalents for the S&P Industrials (Old) posted a seventh consecutive quarter of record holdings ($842.5 billion, up from $836.8 billion in Q1,’10). On aggregate, the value now represents 11.13% of current market value, 75.6 weeks of 2010 estimated operating income, 5 times the annual dividend payment and 4.4 times the last 12 months of buybacks. Cash flow growth for Q2,’10 (preliminary) over Q1,’10 actually outpaced operating earnings: 10.42% vs. 9.94%.

(…) the current level of cash available to companies, either in aggregate or as a comparative metric, has reached an unprecedented level, permitting them for the first time in memory to undertake multi-actions simultaneously.

Cash does not earn much these days so one could say that earnings and ROEs are temporarily negatively impacted by the abnormally high cash levels which earns close to nothing. If we take cash out of the market value, the S&P 500 Index only trades at 13.8x trailing EPS and 12.9x prospective EPS after Q3. No wonder M&A activity has picked up. Corporations want to put this cash in action and they see attractive valuation levels out there coupled with generation low interest rates.

  • The high US government debt is undoubtedly impacting equity valuation. The abnormally slow recovery in the US economy, in spite of huge fiscal and monetary stimuli, is well documented. The challenges and risks to growth are significant and will likely remain for several years given the US debt level and a rather difficult political environment that is unlikely to change positively for at least 2 more years. US equities are currently like a big sailboat in a rough sea, without much engine power, no headsail, a weak jib and a flailing rudder. The boat will likely make it to port but nobody really knows how, when and where. Obviously not everybody’s dream for a cruise.

(S&P 500 charts from Morningstar)


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