Business Insider’s Joe Weisenthal recently warned people of déjà-vu on U.S. equities:


As to his “And we got just as overexcited this time last year.”, may I humbly submit that News-to-Use issued a first warning on Jan. 28, 2011 and another, stronger one, on March 29 (see the complete track record).

In any event, similarities with last year do exist:

On January 28, 2011, I wrote in YELLOW FLAGS ON EQUITIES that

(…) even though valuation remained reasonable, the risk/reward ratio turned less attractive at 1285. Economic trends were suggesting  muddling-through at best, right when economists were becoming more positive.  “Even notable bears have mellowed their stance” and risks of negative surprises were now pretty high.

On March 29, 2011, I warned in US EQUITIES: APRIL PEAK?,  that equities undervaluation was being threatened by rising inflation and dangerous groundhogs.

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 (list followed).

The S&P 500 peaked at 1370 on May 2, 2011. By that time, the U.S. inflation rate had jumped from 1.1% YoY in November 2010 to 2.6% in March 2011 and 3.1% in April, erasing virtually all the undervaluation of the June 2010 (1030) to February 2011 (1328) time frame.

The Q4 2011 earnings season is now over and trailing earnings currently total 96.34, up a mere 1.8% from trailing earnings three months ago (see also U.S. EARNINGS: TAIL WIND TURNING?). With inflation at 2.9%, the Rule of 20 sets fair PE at 17.1x, 1650 on the S&P 500 Index, an appealing 20% above current levels.

That is a big difference with one year ago when the upside to fair value had declined from the 20-30% level between June and November 2010 to 12% in January and 10% in March as sharply accelerating inflation more than offset rapidly rising earnings.

Needless to say, we currently have plenty of known and unknown groundhogs to worry about (Greece, Europe, European elections, Iran, oil, deficits, U.S. elections…).

The savings grace presently is inflation which has declined from 3.9% in September 2011 to its current 2.9% YoY. It has been but 0.8% annualized in the recent four-month period (core +2.1% annualized). But that happened while core CPI was accelerating from +2.0% last September to +2.3% in January. 


Interestingly, U.S. gas prices rose by 15% between October 2010 and February 2011, before exploding 30% during the “Arab Spring” peaking just shy of $4.00 a gallon for the U.S. average in mid-May. While equities lost 8% between May 2 and June 23rd, they recovered most of the losses the next month. The big 20% correction occurred between July 22 and October 4 right when U.S. gas prices were coming back down.

Oil is clearly an important “known unknown” although the impact of rising world oil prices is currently mitigated by falling natural gas prices and very mild weather in America and by high taxes on petrol in Europe.

Shall we be reassured by the Saudi pledge to maintain supplies if Iranian exports stop? The Saudis have repeatedly vowed their friendship to the world amid constantly rising prices (!). For now, given that Saudi Arabia’s budget is based on $100 oil, we should perhaps find some comfort in their recent comments that

(…) it is “able to respond to shortages around the world”.

and that

Saudi Arabia would continue to be a “reliable, steady and dependable supplier of energy to the world”. (FT)


Other known unknowns are also significant:

  • Greece is a patched up balloon waiting to explode but the Germans and the ECB have succeeded in gaining enough time to avoid a full blown crisis when Greece exits the Eurozone.
  • Elections in Greece and France, and possible referendums in many Eurozone countries will likely roil financial markets this spring. (See THE COMING “EURO SPRING”).
  • The U.S. economy keeps surprising on the upside although economists have now revised their forecasts upward so the risks of surprise have become skewed to the negative side. China remains a question mark while its economy is clearly slowing.

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.

imageFew companies have provided guidance for Q1’12 (another negative as such), and those which have were 2:1 more negative. As a result, analysts are scrambling to reduce their estimates as the embarrassing chart from S&P’s Howard Silverblatt shows. This chart is but another good example of the necessity to generally use trailing earnings when valuing equities!

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.

On the other hand, consider the effect of the extremely warm weather North American companies have enjoyed this winter. To illustrate, heating degree days for the Contiguous U.S. declined a huge 17.6% YoY for the 3 months to January 2012. January hdd decreased 20%. Except for utilities, such mild weather should help Q1 earnings for most companies. That said, November and December were very warm months and that did not prevent margins from declining.

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

Will good inflation stats, the orgy of liquidity and exceedingly low interest rates keep equities rising closer to fair value?

History answers “yes” as equities do not tend to stay deeply undervalued for very long (big exception was 1982-85). On the other hand:

  • market technicals are pretty toppish;
  • weak volumes indicate continued cautiousness on equities;
  • the Euro Spring will not be much easier than the winter;
  • the 200 day moving average stands at 1260, nearly 8% below current levels.

On the positive side, let’s not forget that March and April are seasonally among the best months for equities.




Economists and strategists who have dismissed equities in recent times (weeks, months, quarters, years) are quick to conveniently “blame” QEs of all kinds and denominations for rising equity markets. Here’s David Rosenberg:

The record volatility, and 400 point up and down days in the DJIA of last summer seem like a lifetime ago, having been replaced by a smooth, unperturbed, 45 degree-inclined see of stock market appreciation, rising purely on the $2 trillion or so in liquidity pumped into global markets by the central printers, ever since Italy threatened to blow up the Ponzi last fall.

Being neither an economist nor a strategist, my more limited imagination tends to look for more mundane reasons for market moves. The one I generally think of first is earnings. Whatever “financial heroin” Ben Bernanke has showered in recent years, the fact remains that equity markets have generally been in sync with earnings trends.


In fact, a strong case can be made that equity markets have not been excessively boosted by the Fed’s liquidity injections of recent years. Indeed,

  • imageU.S. equities have not fully kept pace with earnings leaving P/E multiples on trailing earnings at 14.1x, below the 15x long term median;
  • equities undervaluation as per the Rule of 20 has remained high in spite of the doubling in equity values since March 2009;
  • P/Es have not benefitted from the extraordinary decline in long-term interest rates.
  • Equity investors, be them individuals, pension or hedge funds, remain underinvested in U.S. equities.
  • Trading volumes have remained pretty subdued.

In all, I am tempted to raise the yellow flag but I have finally decided against it. Here’s why:

  • The liquidity flush has not diminished;
  • Interest rates remain excessively low, offering highly unattractive alternatives to equities at this stage. Recent announcements that some central banks are now buying U.S. equities support this view.
  • Trailing earnings are not declining just yet;
  • Inflation is not threatening a major move upward, leaving equities very undervalued;
  • seasonality is very positive through April.

The 20% undervaluation wins over the 8-10% “technical” downside.

The yellow flag is in the hand but held low, for now!


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