Back from salmon fishing in Iceland. Tiny country, tiny fish, but salmon is salmon, large or small.  Nice country, nice people. Fishing was below expectations but the group, the settings, the chef at the lodges combined to make this a great week.

It was obviously better to be on the river than in the market last week. I expected that (EQUITIES: TIME TO GO FISHING but NOT BOTTOM FISHING! and EQUITIES: CAREFUL OUT THERE!).

First, equity valuation parameters, since April, had not been offering a risk/reward ratio that adequately compensated investors for the current economic and financial risks.

Second, world economies began slowing down early in 2011 but few wanted to see the obvious. One can understand President Obama’ cluelessness about the US economy. On the other hand, Ben Bernanke’s economic analysis in 2011 deserves far less than AA+. To be fair, his qualification of the spring “soft patch data” as “transitory” might have been misinterpreted, although he has yet to admit that he actually meant transitory toward a rough patch (THE ECONOMIC AFTERLIFE).

Third, equities have this habit of offering little to cheer about between the May-October period (US EQUITIES: APRIL PEAK?).

Politicians likewise, although, unlike markets, their performance offers little variation during any given year. Nonetheless, US politicians really outdid themselves this summer: their pitiful show, broadcasted worldwide, received a well-deserved unequivocal Ha-Ha+ from raters across the world. Only a $2T calculation error by Standard & Poors robbed the US of a Ha-Ha-Ha rating.

To summarize, the US economy and its balance sheet are a mess, most Eurozone economies and their balance sheets are a mess and most of the larger Western banks are financial messes. Political leadership is messy, to say the least, and it obviously will be getting messier with the US elections approaching.

To top it all, confidence in fiscal and/or monetary help coming our way has been nullified by the failure of keynesianism and bernankesianism during the last two years.


Great question. First some facts:

With 94% of the S&P 500 companies having reported Q2 results:

  • Q2 operating EPS were $24.88, up a big 19% YoY and up a huge $2.32 (10.3%) QoQ. Q2 EPS came in 4.5% higher than what seemed like elevated estimates.
  • Trailing EPS are now $90.93, up 4.6% from their Q1 level. Annualized Q2 EPS are $99.52.
  • Sales per share rose 11.1% YoY (that number will likely decline this week as retailers report), up from 8% in Q1 and 7.1% in Q4 2010. Energy (+28%), Materials (+18%), IT (+16%) and Consumer Staples (+13%) beat the sales growth average. The other six sectors had a 5.7% sales growth average
  • Operating margins reached 9.26%, up from 9% in Q1 and 8.83% in Q2 2010.
  • 69.6% beat estimates.
  • S&P reports no significant declines in Q3/Q4 estimates yet.

The S&P 500 Index, now at 1181, trades at 13x trailing eps, the lowest PE since October 1990, a recession low. It also sells at 11.8x the annualized Q2 EPS.

The reliable Rule of 20 fair PE is currently 16.4x (20 – CPI of 3.6%), indicating that the S&P 500 Index is undervalued by 21%, a very rare occurrence (click on chart to enlarge).


Although rare and appealing from a value stand point, the current 21% undervaluation is not a guarantee of positive returns. In the last 90 years, similar undervaluation levels have not been followed by positive returns in the following circumstances:

  • Major war.
  • Deflation.
  • Rapidly rising inflation.

US inflation has been rising at a fast clip in 2011, from 0.8% in January to 3.6% in June (July CPI to be released Aug. 18). This very rapid rise in the deflating component of the Rule of 20 has been a major factor in my downgrading of equities during the early part of 2011. In effect, the S&P 500 Index went from a 21% undervaluation in November 2010 (1185) to a much less appealing 7% undervaluation last June (1320). The rise in the inflation rate cut the Rule of 20 fair PE by 2.8 points, offsetting the 14% jump in trailing earnings during the period.

Investors were obviously too focused on rising earnings, paying little attention to the rise in the CPI and its impact on valuation. Bernanke & Co. probably contributed to the market blindness, substantially playing down the inflation threat, hammering the “transitory nature” of inflation.

However, they may well eventually prove right on this, given the way the economy is going, a total surprise to the Fed and to the economist community in general, who also used “transitory” to qualify the spring’s soft economic data. Fortunately, my readers have been repeatedly warned that the world was actually not transiting to anything pleasant (THE ECONOMIC AFTERLIFE (June 6), EQUITIES: TIME TO GO FISHING but NOT BOTTOM FISHING! (June 13), THE US ECONOMY NEEDS ANOTHER “MIRACLE” (June 17), EQUITIES: CAREFUL OUT THERE! (July 7).



Previous large discounts during corrections have been: August 2010: 23%, October 2006: 14%, December 1994: 14%, November 1988: 21%. A 20% undervaluation would be at 1140, another 14% drop which, added to the 4% correction from the recent peak, would give a 17% setback, almost another bear.

Being there now, what should we do? Buy that big dip, sell before the real bear or keep on fishing until things clear up?

  • This is no ordinary crisis. We are clearly in uncharted territory with the euro crisis, the US economic, financial and political blight combined with capital shortages at many major Western banks. We have 2 major regional crisis, feeding each other, and threatening some of the very large lenders in the world. These banks, unsurprisingly, are retrenching, unwilling to lend and encouraged to do so by monetary policies. Alarmingly, as Barron’s Alan Abelson reports,

(…) in recent weeks interbank lending has been drying up at an alarming rate. And for that decidedly unpleasant development he fingers the recent EU stress tests. Just about all the major institutions passed the test, which hardly was surprising since it wasn’t terribly rigorous. But, as it happens, disclosure of the test results included greater transparency of their assets and capital, enabling the big banks to more keenly size up one another’s strengths and weaknesses.

The results of such revelations were not entirely salutary, occasioning, as Harald (Malmgren) avers, “declining trust of euro-zone banks in relations with each other.” Or, as he puts it, while few Euro banks failed the stress test, many failed what might be called the “interbank trust test.”

  • So, this is not unlike 2008 when Lehman was let go belly up and financial markets froze. The big difference is that governments are now much less capable to stimulate their flailing economies and support the weaker banks.
  • How will this unfold? Nobody really knows. But few reasonable people would bet their last dollar on politicians finding and implementing the right medicine.
  • Cheap equities, but the risks remain high and unpredictable.

Let’s try a few scenarios for a moment:

  • Recession causes earnings to decline. They collapsed 40% or so 1930-31, 1938 and 2008-09, 26% in 2000-01 and in the 15-20% range in other recessionary periods. Using the worst case, a 40% drop in EPS would bring them back to the $60 range. If inflation is then at 2%, fair PE would be 18x for a target of 1080 on the S&P 500 Index, another 10% drop. Not that bad for a worst case scenario… But it is not the worst case.


  • Deflation. Prices decline under very poor demand. Recession ensues and EPS collapse 40% like in the deflation years of the early 1900s. All bets are off. Don’t even think of buying equities.
  • Inflation shoots up to the 5-6% range. Fair PE drops to 14-16x which, to justify current prices would require EPS of $75 to $85. Not unreasonable but nothing to incite buying stocks here. Unless earnings keep rising as central banks are not unhappy to let inflation rise for a while. With EPS in the $105 range in mid-2012 and inflation at 5.5%, the S&P 500 Index could reach 1500. The question is, can we avoid a recession if inflation reaches 5% with unemployment at 9% and little, if any, government support?

Interesting exercise. Some may want to gamble on scenario 3. For my part, given that we are only in mid-August (see SEASONALITY OF EQUITY MARKETS) with so little visibility and such high volatility, I remain on the sidelines for a while longer even though my fishing season is over (sigh).


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