The S&P 500 Index has more than doubled in the last three years in what has been an extraordinarily unpopular market recovery. Thanks to the internet, particularly to the blogosphere, everybody is now able to express and discuss his opinions and make them widely available. Since 2008, the bears have been a constant feature in the media, their views being happily megaphoned throughout the web and in the conventional media. Given that the last decade bred large herds of understandably angry bears (see BUT, WHO’S THE PIPER?), they have occupied the scene probably like never before.

As equity markets were recovering, bulls remained generally subdued while increasingly frustrated bears got more and more vocal about everything negative throughout the world which, suitably, never stopped providing them with highly fertile feeding grounds.

image_thumb1_thumb2Now that equities have bounced back 20% from their October 2011 low and that the U.S. double dip scenario is losing popularity, it seems that fewer people are trying to stop the bull. The media are more open to positive views on the stock market. This week’s Barron’s carries a front page article Enter the Bull while the FT is somewhat more prudent with its The bulls return, but for how long?

Even Alan Abelson is trying to sound bullish:

And we don’t think last week will necessarily translate into fini for the advance. Rather, we suspect animal spirits had gotten a bit out of hand. (…) On that score, we found more than a tad discomforting the very buoyancy of the market, as investors espying what they took to be a significant bullish move began, hesitantly at first, then more and more assertively, to take the plunge. The sentiment figures of both pros and individuals present unmistakable evidence of swiftly gathering enthusiasm.

Michael Santoli, after spending most of his Barron’s column suggesting that the market is eerily resembling 2011, ends with a wishy-washy, say-it-all, but nevertheless seemingly optimistic series of words

The evidence, then, points to a correction, but higher prices likely will follow. Absent one of those nasty shocks we’ve almost come to expect, the market can weather any near-term setback well.

Nouriel Roubini also turned bullish last week (see the EQUITIES section of Feb. 8, 2012 NEW$ & VIEW$). Nomura Securities discarded the proverbial Japanese politeness when it published the following chart in their market comment last week. Among their “Six Reasons To Worry”, the first one listed was the news that Roubini has turned bullish (chart via Brazilian Bubble).


Last Friday, Chart of the Day came up with a chart supporting the increasingly popular idea that this “rally has legs”:

To provide some perspective to the current Dow rally that began back in early October 2011, all major market rallies of the last 111 years are plotted on today’s chart. Each dot represents a major stock market rally as measured by the Dow. As today’s chart illustrates, the Dow has begun a major rally 28 times over the past 111 years which equates to an average of one rally every four years. Also, most major rallies (78%) resulted in a gain of between 30% and 150% (29.8% to 150.5% to be exact) and lasted between 200 and 800 trading days (9.5 months to 3.2 years) — highlighted in today’s chart with a light blue shaded box. As it stands right now, the current Dow rally (hollow blue dot labeled you are here) would be classified as well below average in both duration and magnitude.


Interestingly, the new bulls’ vocabulary makes little use of words like earnings or valuation. The leading Barron’s article cited above has but a small paragraph on potential earnings growth in 2012-13 and the resulting “reasonable” P/E ratios. The FT’s piece has a single phrase about the apparent low P/E, concentrating on the “improving” economic situation and technical and historical considerations. History is the backbone of Barron’s story as it draws on Wharton School finance professor Jeremy Siegel’s research on the past 141 years of equity performance

from which a fairly straightforward cyclical pattern can be discerned: a strong tendency for periods of worse-than-average returns to be followed by periods of better-than-average, and vice versa. Since the past five years have been squarely in the worse-than-average category, better-than-average returns in the two-year period just begun are now likely.

The bulls of 2009 must be wondering why this “fairly straightforward cyclical pattern” could not be so readily discerned 3 years ago and how the 102% return of the past 3 years fit within the expected “better-than-average returns in the two-year period just begun”.

I have always been amazed by the fact that so many people writing about equities, be them journalists, economists but even strategists or equity analysts, can write long essays, delving on economic, political, technical and historical matters without spending much time on earnings and how much these earnings can be worth.

Earnings are the lifeblood of equities. Earnings multiples are the value amplifiers of said earnings. Prudent investors should focus on trailing earnings, which necessitate little research efforts and limited economic input. They should also endeavor to understand the behavior of P/E multiples in order to constantly monitor the risk/reward ratio. These two tasks being completed, THEN one can take the time to figure out which way the economic, political, technical and historical winds are blowing in order to complete the risk/reward analysis and take appropriate investment actions in accordance with one’s particular investor profile.


We should not ridicule the new bulls. First, we sure need them at this stage. Second, there is always a chance that they be right, even though many economists and analysts succeed in making a lifelong business by being generally wrong.

Earnings are peaking. With 82% of companies having reported so far, Q4’11 EPS are 5.3% lower than Q3, the first quarterly decline since Q3’07.

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Trailing 4Q EPS should reach $96.65 after Q4 earnings are all in, a mere 2.1% above their level after Q3’11. If analysts are right on their $24.00 Q1’12 estimate, trailing EPS will only be up 1.5% during the next 3 months.

The significance of the earnings slowdown is easily understood when one considers that trailing earnings have increased 125% since March 2009, coincident with the 103% equity recovery during the same period. Trailing earnings troughed in Q3 2009 but quarterly EPS bottomed in Q4’08, just before equity prices troughed in March 2009.

Trailing earnings have gained 15% during 2011. This tail wind for equity markets has almost disappeared, just as the new bulls are arriving with their market forecasts deprived of much earnings analysis. True, analysts continue to see earnings rise, their Q4’12 estimate being $28.21, up 17.8% YoY. But they may be overseeing these facts:

  • profit margins are at an all-time high and appear to have peaked out;
  • productivity rose only 0.5% in Q3’11 and 0.2% in Q4’11 after reaching +6.2% in Q1’10. Unit labor costs were +1.5% in Q4’11. They had declined 0.8% in 2009 and 2.0% in 2010. The offset to rising employment is declining productivity and increasing labor costs.
  • the U.S. economy may have avoided the double dip but it remains on slow speed;
  • Europe is weak any which way we look at it;
  • China is slowing and Beijing could be misreading the situation or fail to re-stimulate on time or sufficiently;
  • inflation is also slowing, providing little fuel to revenue growth.

All this to say that trailing earnings have ceased to be supportive to equity markets unless the economy gets surprisingly stronger and/or inflation accelerates. In addition, analysts appear to be on the optimistic side for the rest of 2012 and investors should be prepared for negative earnings revisions in coming months, never a positive.


The new bulls are thus dependent on rising P/E ratios for their better mood to prove justified. At its current 1350 level, the S&P 500 Index is selling at 14x trailing EPS, only 7% below its historical 15x median. However, the more dependable Rule of 20, which takes inflation into account, says that the fair P/E should be 17x with inflation at 3%, setting fair value at 1643, +22% above current levels.

The problem is that trends in P/E ratios are much more difficult to foresee than earnings, especially trailing earnings! Obviously, positive economic, political and technical backgrounds would greatly help lift investor sentiment which would normally translate into rising earnings multiples. Here’s my reading on sentiment:

  • imagethe Citigroup Economic Surprise Index has reached its historical high level and has been moving sideways since December 2011. The best we can hope is that the economy stays good enough to meet already more upbeat economists forecasts;
  • Europe is unlikely to provide much good news in coming months. In fact, the Eurozone 2012 political landscape looks pretty dangerous (see THE COMING “EURO SPRING”);
  • Needless to say, the U.S. political scene provides little hope for anything uplifting for a considerable while.

The new bulls are thus certainly welcome even if they speak more technically than fundamentally. Given the state of the world, help is needed from all corners.


Fortunately, Big Ben is towering on financial markets. His QEs of all denominations, what Don Coxe calls “the Fed’s financial heroin”, are keeping interest rates, short and long, low enough and liquidity high enough to stuff even a nervous bull. Most other central bankers are also stuffing the grizzly, even the generally reserved ECB whose new Italian skipper is proving more German in his talk than in his walk.

As importantly, inflation may be slowing even more. The Rule of 20 states that fair P/E is 20 minus inflation. If U.S. inflation falls to 2.0% YoY, fair P/E would rise to 18x, providing another 6% upside potential.


The current 22% undervaluation of equity markets is rather exceptional. Since 1956, there have been only 9 periods of 20%+ undervaluation under the Rule of 20. Four of these instances have lasted more than 6-9 months. In all cases but 2, equities rose strongly afterward.


The two periods when equities needed time (years) before roaring back to life were 1956-58 and 1976-78, two periods marked with accelerating inflation. Even during 1982-86, when deep undervaluation remained extreme, equity prices rose strongly from 107 in July 1982 to 242 in December 1986. Earnings rose only 27% from 1982 to 1986 but inflation dropped from 8% to 1%. Under the Rule of 20, such a drop in inflation, by itself, increases fair value of equities by 60%.

Stocks got carried away during 1987 even though earnings flattened and inflation accelerated. The Rule of 20 fair value was reached in early in 1987 at 290 on the S&P 500 Index which reached 16% overvaluation in August at 330. Post the October crash, the Rule of 20 flagged undervaluation of 13% which subsequently rose to 21% one year later as earnings shut up 33% and inflation stayed unchanged at around 4%. Meanwhile, the S&P 500 Index gained 19%.


Equities are not cheap for no reason. Investors have plenty to worry about which generally brings good investment opportunities. The old contrarian saw

Buy at the sound of cannons,

Sell at the sound of violins.


is often very useful when things get murky and complicated. Currently, the cannons are roaring in Europe. The problem there is that the uncertainty level on Europe is, like the debt level, extreme and global banks are right in the middle of the battlefield. Markets would no doubt get very nervous on the outcome of a Eurozone breakup, the probability of which is far from negligible at this point.

Unless the U.S. economy starts weakening again, equity markets will likely trend up but remain highly nervous and dependant on Europe.

The bulls are back, but as people of Pampelona know, it’s better not to be totally in front of the herd, unless one runs very very fast…


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