Earnings season is almost here again. Let’s recap where earnings stand:

  • Q4 2010 S&P 500 Index EPS came in at $21.92, +27.7% YoY.
  • Trailing 4Q EPS are now $83.76, + 6% from Q3 2010.
  • The Q4 annualized rate is $87.68, only 1.7% higher than Q3’s.
  • Quarterly EPS have been losing momentum since their Q1 2010 level of $19.38. The QoQ growth rate has declined from +12.9% in Q1, to +7.8% in Q2, +3.2% in Q3 and +1.6% in Q4.
  • The consensus estimate for Q1 2011 is $22.04, +13.7% YoY but only 0.5% higher than Q4 2010. If right, trailing 4Q EPS will be near $86.50 by the end of May.
  • The consensus estimate for 2011 is $96.23, + 14.9% over 2010.

Beware of estimates at this stage of the recovery. Street analysts generally overestimate, the only exceptions are after recessions when they typically underestimate (see BEWARE OF OVERLY OPTIMISTIC ANALYSTS).

  • Earnings revisions continue positive but history shows that the period of upward revisions is nearing the end of its normal duration.
  • Interestingly, corporate guidance is much less buoyant.


(Charts from GTAA via FT Alphaville)


  • At 1315, the S&P 500 Index PE on trailing EPS is 15.7x, slightly above its 15x median within the historical 10-20 range. Notice how the PE has stayed above 15 when inflation (black line) is muted.


  • The Rule of 20 takes into account changes in inflation rates to help set fair PE under different inflation environments.
  • Recent US inflation data put YoY CPI at +2.1% and core CPI at 1.1%. However, during the last 3 months, total CPI has risen at a 5.3% annualized rate with median and core CPI both at 2.0% annualized rates.
  • Using 2.0% inflation (now conservative. Only a few months ago, deflation risk was high), the Rule of 20 fair PE is 18x (1500) but it declines by 1.0 point (5-6%) for each 1% variation in CPI.
  • Accordingly, the S&P 500 Index remains undervalued by 12% but that is highly sensitive to the current inflation scare. Inflation at 3% puts fair PE at 17 (1423), a mere 7% undervaluation.


While the Rule of 20 provides a rigorous mathematical and time-tested approach to PE multiples on US equities, it does not account for external risks. While many external factors are at play at any given time, it is fair to say that the current environment has more than its fair share of known unknowns (see KNOWN AND UNKNOWN UNKNOWNS (GROUNDHOGS)), many of which are potential game changers:

Liquidity is currently flowing liberally in the US economy and into its stock market. Yet, many of the above noted groundhogs could quickly change the outlook significantly. In addition, the era of excess liquidity could well end abruptly on June 30th or, more likely, fade away gradually during the summer months.

It is therefore likely that high uncertainty will keep PE ratios below what they would otherwise be in a more “normal” environment.

This is why caution is warranted here. It will be psychologically very difficult for investors to bid stocks up when PEs are no longer terribly attractive and given the number and dangerousness of the groundhogs out there.


April is statistically one of the better months for equities as detailed by this chart from Doug Short. Between May and October, the risk/reward ratio is statistically much less appealing.

Indeed, many technical indicators for equities such as MACD and RSI have recently turned positive on the S&P 500 Index as well as on the FT100.

Meanwhile, other contrarian indicators are appealing as these charts from RBC Capital Markets suggest:


The recent resilience of equity markets, surprising many groundhogs-focused bears, may be the result of ample liquidity coupled with pretty positive economic news. However, economic data have recently surprised on the wrong side as revealed by Citigroup’s US economic surprise index (right chart below).



To be sure, April will be a most interesting month.

  • The ECB meeting on April 7. Here is how FT’s Gavyn Davis sees this:

This leaves the ECB in an unsatisfactory position. It is having to contemplate a tightening in monetary policy without having off-loaded responsibility for liquidity support operations to the fiscal authorities, which is where the ECB wants them to be. However, there are no signs from ECB spokespersons that this will lead them to rethink their stance on interest rate policy. I have counted five council members saying in the past few days that “strong vigilance” remains in place, and that the oil and earthquake shocks have had no impact on their thinking. It therefore seems that the EMU zone is about to embark on a new experiment, which is to tighten monetary policy before  sorting out the fiscal mess in several countries. Good luck!

  • April will unload many March economic data from China, post the so-called holiday-impacted January-February stats that are said to blur real trends amid the government fight against inflation.
  • The FOMC meeting of April 26/27, followed by Ben Bernanke’s first press conference. Gavyn Davis again:

In the past week, we have heard several hawkish noises from FOMC members such as Charles Plosser, who were always sceptical about QE2, and who are now preparing for the debate on the exit strategy which will take place at the FOMC meeting on April 26/27. Mr Plosser argued in an important speech that it would soon be time to start withdrawing monetary stimulus, and proposed a plan under which the Fed would simultaneously raise interest rates by 25 basis points at a time, and also sell $125bn of Fed assets each time rates were increased. Mr Plosser is clearly at the hawkish end of the FOMC spectrum, but this is a much earlier and tougher exit programme than anyone had previously discussed in open debate.

Several other FOMC members who are thought to be near the centre of the FOMC, including Messrs Kocherlakota, Lockhart, Evans and Bullard, also made hawkish-sounding noises this week. James Bullard is particularly interesting. He was seriously concerned about deflation last year, and was one of the earliest on the FOMC to contemplate QE2. Now, he says that the Fed should be debating whether to end QE2 earlier than the end of June, and he says that this applies “particularly” to the meeting in April. Mr Bullard has always believed in taking small and frequent steps on QE in both directions, but this does indicate the looming importance of the April meeting. With Mr Bernanke scheduled to give the first of his scheduled press conferences on April 27, the next month is going to be a vintage time for Fed watchers.

In all, upside to fair PE levels remains and could be reached during the statistically strong April, especially if earnings season provides more positive surprises. Equities are no longer very cheap, especially when considering the significant groundhog risks surrounding us. The economy is improving but this is feeding into the Fed’s conditions to remove the huge liquidity and excessively low interest rates which, combined with strong earnings, are sustaining risk appetites. Perversely, it is also feeding inflation which, if not controlled, will undermine economic growth and equity valuation.

The spectacular and unrelenting rise in US equities have recently broken many bears, growing the chorus of bullish voices. Beware the enchanting music.


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