The Q4’11 earnings season is over and U.S. inflation data for February were released last week. It is time to revisit the Rule of 20 and assess the outlook for equities.

As a reminder, I turned positive again on November 17, 2011 (TIME TO INCREASE EQUITY EXPOSURE) at 1221 on the S&P 500 Index which was then selling at 12.9x trailing EPS with inflation at +3.5% YoY for October.

Under the Rule of 20, the appropriate PE should be 16.5 (20 – 3.5) which, using $94.75 trailing EPS gives a fair value of 1563 for the S&P 500 Index. As the chart shows, the current 22% undervaluation is very rare and has been a strong buying signal.

Now that US recession risks have significantly diminished and that inflation seems to be receding, both earnings and valuation risks have decreased meaningfully.

Of course, risks remain, particularly from the political side. This is why valuation is so attractive. However, the Euro risk has entered its “terminal” phase and while US politicians continue to act … as mere politicians, the resiliency of the economy and the easing of inflation, coupled with extraordinarily low interest rates promised for “an extended period” and ample liquidity, provide a good background for US equities.

Five months later:

  • The S&P 500 Index is at 1400, up 14.9%.
  • Trailing earnings are up 1.7% to $96.42.
  • Inflation has decelerated to 2.9%

Based on these factual parameters, the Rule of 20 says that fair value for the S&P 500 Index is 1650 (17.1 x $96.42), nearly 18% above current levels, somewhat less undervalued than last November but nonetheless pretty attractive.

On March 5, I discussed the potholes on the road toward fair value (U.S. EQUITIES: NERVOUS GREEN LIGHT!), highlighting all of the well known problems in the world but focusing on the most important factor: earnings (see also U.S. EARNINGS: TAIL WIND TURNING?) :

Yet, to me, the biggest risk lies with earnings which, ex-Apple, have declined 9.7% QoQ  in Q4. This is a pretty big event since first quarterly declines exceeding 8% have happened only 4 times since 1988. On the other hand, a second consecutive quarterly decline only happened in Q3 2007. Not much of a trend setter, but -9.7% is indeed a big decline when valuing equities on trailing earnings.

Some facts on earnings:

  • profit margins peaked in Q3’11 and declined 85 bps in Q4;
  • productivity rose only 0.5% in Q3’11 and 0.2% in Q4’11 after jumping +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; as Peggy Noonan wrote, “the economy is coming back, at least for now and at least a little;
  • 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;
  • slowing inflation provides little fuel to revenue growth.

My conclusion still holds:

In all, until proven otherwise, investors should now assume that the earnings tail wind for equities has stalled.

Consensus estimates for Q1 EPS have stopped falling and are now $23.79, up from $23.71 two weeks ago and +5.4% YoY. Q2 estimates now stand at $25.91, +4.2% YoY, and appear more at risk than Q1 estimates. Obviously, next earnings season, starting in mid-April, will be watched with trepidation.


Meanwhile, the other parameter in the value equation is behaving reasonably. The U.S. CPI rose 2.9% YoY in February and appears set to stay below 3% for a few more months.

  • Monthly inflation was 0.4% in February. Even if it continues at that rapid pace through May, the YoY increase will remain below 3% since monthly inflation averaged 0.4% between March and May 2011.
  • Core CPI has been rising between 0.1% and 0.2% MoM for 9 months running (0.1% in February), indicating little inflationary pressures outside of food and energy. If it continues at that pace, core inflation will remain at 2% or less through May.
  • Food at home inflation peaked at 6.3% YoY last October. Since then, monthly increases totaled only 0.2%. Food prices jumped 1.0% MoM in March 2011 and another 0.9% in the following 2 months. If they remain stable in coming months, the YoY increase will decline below 3%, somewhat offsetting the increase in energy prices.

In all, the Rule of 20 fair value for the S&P 500 Index is likely to remain stable around the 1650 level for the next several months.

This is the first time since August 2011 that the Rule of 20 fair value is stabilizing (see with line in chart below). The last time the Rule of 20 fair value stopped rising was between November 2010 and July 2011 as inflation accelerated from 1.1% to 3.8%. This 270 basis points rise in inflation shaved 13.5% off the fair PE (2.7/20) more than offsetting the 10% gain in trailing EPS during the same period.

U.S. equities were 26% below fair value in November 2010 but as they rose 12.8% while fair value declined under the pressure of rising inflation, the undervaluation dropped below 10% in April 2011 which triggered my March 29, 2011 warning US EQUITIES: APRIL PEAK?.




The numerous problems in the world are well documented by economists and strategists, especially those of the bear types. There are admittedly fewer of these ursids nowadays (THE BULLS ARE BACK, RIGHT ON CUE) in spite of the fact that earnings might be peaking.

The big difference with the current situation compared with last year’s is that the risk is currently centered on earnings while in both 2010 and 2011 rising inflation was the reason for valuations getting less attractive. Changes in inflation rates are more gradual than earnings movements which can, at times, be sudden and violent. Thus, risk is more significant at this point than last year, something which we must integrate into the risk/reward analysis.


The S&P 500 Index 200 day moving average currently stands at 1263, indicating a 10% downside to this important trend line. It is rising but at a snail’s pace. More fundamentally, a return to a 25-30% undervaluation like in 2010 and 2011 would set the S&P 500 back to the 1150-1240 range, 12-18% below current levels, declines similar to those of the previous two springs.

The 18% upside to fair value remains superior to the downside but not much. A more balanced risk/reward equation would be reached near the 1450 level, only 3.3% above current the current level.

Of course, the above analysis assumes normal odds of getting back to fair value as defined by the Rule of 20. The last time we reached fair value was in December 2009 (US EQUITIES VALUATION ANALYSIS: DUCK, YOU (HAPPY) SUCKERS!). In 2011, we got only within 9% of fair value as oil and Europe made things pretty complicated for investors.

This time around, there is oil, Iran, Europe, China, the U.S. fiscal cliff, elections in Greece, France and the USA. And, of course, EARNINGS! Investors are much more susceptible to adverse macro events when the risk/reward ratio is not compelling.

Many commentators are reminding investors of the fact that equities peaked in the spring of both 2010 and 2011. So the next 8 weeks will be challenging because everyone, all mindful of left tail risk and knowing everyone might want to “sell in May and go away”, might want to get ahead of the pack and sell in April.

In 8 weeks, Q1 earnings season will be almost over. Let’s see how it goes. Meanwhile, assess your equity exposure, manage your risk and watch the technicals.



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