CHEAP EQUITIES + NO DOUBLE DIP + FED PUTS = BULLISH

Q3 earnings season is over and while the total tally is not complete,  S&P Index EPS likely came in at $21.50 in Q3 or $86 annualized. This would bring trailing 12 months EPS to nearly $79 (see Q3 2010 EARNINGS SEASON RECAP).

At 1200, the S&P 500 Index is selling at 15.2x TTM EPS, in line with the simplistic PE15 average.

However, under the more appropriate Rule of 20 valuation method, the S&P 500 Index is 20% undervalued on its fair value level of 1485. Under the Rule of 20, fair PE is 20 minus inflation (1.2% in October) or 18.8x trailing earnings.

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The valuation background is likely to keep improving throughout the winter months since Q4 EPS should easily beat the 2009 Q4 figure of $17.16, potentially bringing TTM EPS in the $83-86 range.

Fears of a US double dip have declined meaningfully in recent weeks as economic data has been improving somewhat. Only today, the news was far from suggesting a double dip:

  • US initial unemployment claims rose 2k last week but the 4-week moving average hit a new low at 443k for this recovery, its lowest level since September 2008.
  • The Conference Board leading economic indicator rose by 0.5% in October, matching the revised increase seen the prior month. Six of the 10 measures making up the index were positive, lead by interest rate spreads, stock prices and real money supply.

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  • The Philly Fed Business Outlook Survey jumped from a reading of 1.0 in October to 22.5 in November. This is the highest reading in the index since last December. Indexes for new orders and shipments also improved this month, and each index increased 15 points. Indexes for both delivery times and unfilled orders changed from negative to positive this month, suggesting improvement. Labor market conditions also showed some improvement this month, paralleling the improvement in other broad indicators. This month, firms also reported some growth in employment and a longer workweek. The index for
    employment was positive for the third consecutive month and increased 11 points. The average workweek index increased significantly, from ‐6.0 to 10.9. (See also PHILLY FED SURVEY BACK IN SYNC)

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  • US retail sales have recovered nicely in recent months and auto sales have picked up.

On balance, the macro data has come in better than expected. Since late August, economic data have consistently beaten
expectations.

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Risks remain, of course. The main one, from a valuation viewpoint, is deflation (US CPI CLOSER TO DEFLATION and DEFLATION DANGERS). This is precisely what the Fed is trying to avoid through QE2 and its eventual siblings if and when needed.

 

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