US EQUITIES 10% UNDERVALUATION NOT VERY APPEALING

Mid-way into the earnings season, Standard & Poors calculates that Q1 earnings will come in at $22.64, up 16.8% YoY and 3.2% QoQ. That would be 2.3% higher than the $22.13 consensus estimate of one month ago, a small but nevertheless positive surprise.

Trailing 4-quarter EPS would total $87.03, up 3.9% from 2010 EPS. Annualizing Q1 EPS gives $90.56, only 4% above trailing 4QEPS as quarterly earnings growth has flattened out considerably in the last 9 months.

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On that basis, the S&P 500 Index (1365) is selling at 15.7x trailing EPS. This is unchanged from March 29 and up only slightly from the 15.3x level at January 28 given that the market has risen essentially in line with earnings.

What has changed is the inflation rate. YoY CPI inflation for March is 2.7%, up from 2.1% in February and 1.6% in January. Under the Rule of 20, this 1% rise in the CPI cuts the fair PE by 5%.

Fair PE is now 17.3x trailing earnings, or 1505 on the S&P 500 Index, 10% above current level.

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This is the smallest level of undervaluation since April 2010 when the Index reached 1188, before retreating 15% to 1010 in early July 2010 when undervaluation was back at the more appealing 20% level.

Revenue growth has accelerated very nicely: Q1 sales per share are estimated to gain 13%, up from 7% in Q4 2010. However, most of the jump is in Energy and Financials while two of the leading sectors so far in this recovery, industrials and technology, are seeing a slowdown in their sales growth rates.

Earnings rising along with inflation is not positive. Rising inflation is the worst enemy for equity investors as it erodes the fair PE and increases the risk of monetary tightening and economic slowdown/recession.

As mentioned, US CPI growth has accelerated from 1.6% in January to 2.7% in March. Since November 2010, the CPI has risen at a 5.5% annualized rate. Meanwhile, core CPI growth has been more muted, rising from 1.0% YoY in January to 1.2% in March. Its annualized growth rate is 1.8% since November 2010.

Investors must decide if Ben Bernanke is right on the transitory nature of commodity-based inflation, although the Rule of 20 is constructed on total CPI. Nevertheless, inflation expectations have not changed much recently, backing Bernanke’s views (see BERNANKE’S INFLATION BET LOOKS GOOD). A slowdown in US inflation in coming months would likely push equities higher toward the 1500 fair value target, unless the market trips on the numerous groundhogs around (KNOWN AND UNKNOWN UNKNOWNS (GROUNDHOGS)), the list of which is not any shorter from that of last month.

A few of the groundhogs moving beneath our feet:

Crude oil prices have gained another 25% in the last 3 months, nearly 10% in the last month. The geopolitical situation in MENA has not improved. Japan’s outlook has worsened. Interest rates have been raised in Europe and European inflation is accelerating. China remains problematic. Chinese equities show no clear sign of optimism. In the US, the fiscal situation remains dire as QE2’s ending approaches.

These are serious, game changing groundhogs, which weigh in seriously against the 10% apparent undervaluation. Also, remember that equity markets are entering a five month period that has been statistically less rewarding (see SEASONALITY OF EQUITY MARKETS).

Hence, my yellow light.

 

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