SWISS CHEESE

Back from a great trip across beautiful Switzerland (see also PREPARING THE DAVOS ECONOMIC FORUM). What struck me most:

  • Construction cranes everywhere.
  • Babies everywhere.
  • Watches everywhere.
  • High prices (!) everywhere, except on beer and wine.

The offering of watches of all sorts and all prices, everywhere you go, is truly amazing. To the point where I finally elected to buy one even though I have quit wearing a watch nearly 30 years ago. Suzanne and I also decided to buy a Swiss mantle clock. Both of which we chose in Switzerland… but will be buying in the US!

The clock is selling for about 1,000 CHF in Zurich and Geneva. A quick check on Google revealed that Bill’s Clockwork, a US registered dealer for this particular manufacturer, is selling it for 36% less!!

The watch was selling for 695 CHF at all retailers having it in stock. A quick check on Amazon saved me an immediate 25% but a more in depth research allowed me to buy it new on Ebay at a 38% discount. Holes in the Swiss cheese.

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Most of the economic data released since Christmas, in the US and abroad, brought a cheesy smile to investors, raising confidence that the world economy was on the mend.

Employment remains slow to improve, however. This is Gruyere cheese, even more so when considering the Eurozone crisis.

Equities have been gaining under this improving climate, even against rising long-term rates (see WILL RISING BOND YIELDS DERAIL EQUITIES?). Yet, valuation under The Rule of 20 remains attractive. With trailing EPS of $79.00, the S&P 500 Index is selling at 16.4x. Inflation being around 1.0%, the Rule of 20 calls for a 19x PE, indicating a 14% undervaluation at current levels of 1293.

Q4 2010 earnings season is underway. Current estimates are for EPS of $21.81, essentially unchanged since mid-2010 in spite of surprisingly strong results throughout 2010 and generally positive guidance from companies at the end of Q3.

Full year 2011 estimates are $94.96, up $1 since September. That would be 13.5% above the expected 2010 total. Given that revenue growth runs at about half that rate, can we reasonably expect costs to decline again?

Tough call: input costs are rising fast as commodity prices remain very strong; and if employment turns up, labor productivity will certainly decline. On the other hand, what will happen to effective US corporate tax rates in 2011? Moreover, share buybacks are in vogue again, helping reduce shares outstanding, thereby boosting EPS.

Fortunately, there is no need to use estimated earnings to justify buying equities. Valuation on trailing EPS is still reasonable. The Fed remains very pro-equities and inflation, at least in the Western world, is not a big threat. In fact, a little more of it would be welcome: revenue growth would improve and deflation risks would diminish.

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Also, keep in mind that US corporations are flush with cash (see CASHING IN WITH CASH).

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Here are a few of the bigger cheese holes, courtesy of Gluskin Sheff’s David Rosenberg:

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