Bloomberg recently ran a top story with the title “Economy of US Enters Sweet Spot as China’s Growth Slows” claiming that the U.S. has become the main engine for global growth. At the same time, as U.S. equities rose past the 1400 level, we are beginning to read pieces clamoring that equities are the choice investment vehicle for the next decade, if not the next generation, using all kinds of reasoning to support their arguments. Some things will simply never change.

I don’t know about you but, personally, I find it impossible to have any solid economic and financial scenario beyond the next 12 months, and even that is a bit of a stretch. Consider:

  • Europe just escaped Armageddon but is nowhere near stability, let alone growth. Recent PMI data reveal that new orders weakened at an accelerating pace in March. The probability that Greece soon loses its “Greece is unique” status to Spain and/or Portugal is high and rising daily. And Italy? Not out of the woods yet, is it? Keep in mind that while we tend to analyze each of these countries separately, they are part of a tightly knitted economic area and are all significantly intertwined. Greece’s problems reverberate on their trading partners. So are Italy’s and Spain’s, etc. These are all neighbors with compounding effects one on the others. The fiscal drags in these countries is significant and continue throughout 2013 (see RBC chart below), eroding further an already reduced purchasing power.


  • Germany is weaker than thought, not only from the Eurozone woes but from a weak domestic economy as Germans keep a tight lid on their purse for reasons that are far from their own economic conditions. France is also not humming economically.
  • How the Eurozone saga ends, nobody really knows. What we know is that economic recovery is not in sight yet and many are worried that the severe austerity measures will have the unintended consequence of deepening the crisis.
  • Eurozone banks remain fragile and the ECB might not be able to keep patching for very long.
  • China is also going through a softer patch. Europe is its main trading partner, wages are rising and its domestic economy is fighting its own housing difficulties. Can it limit the slide to a soft patch? All bets are off.
  • The U.S. has admittedly been the only area with improving economic momentum. While many attribute the apparent recovery to a very early spring, actually begun last November, the fact is that America is doing better. But “how much better” is now a more important question given that the U.S. consumer has significantly reduced its savings to sustain consumption in the last 6-9 month. The U.S. is not as dependent on exports as most other nations (see the JP Morgan chart) and Canada, its main trading partner, is doing reasonably well. It remains that North America is far from booming and the U.S. will eventually (i.e. after the November elections) need to face its own fiscal challenges.


  • Oh! Did we discuss oil prices, Iran’s nuclear ambitions and Israel’s concerns, the French elections, the U.S. elections?

All this to say that saying anything about the rebirth of equities is wishful thinking at this stage, especially after equity markets have doubled in 3 years.

Let’s not forget that equities are about earnings and earnings multiples.


The Q1 earnings season starts April 10, culminating April 26 and ending May 3rd. The last earnings season did not go very well unless you own AAPL. Here’s what I wrote on March 5:

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.

I concluded:

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

Since I wrote TIME TO INCREASE EQUITY EXPOSURE on Nov. 17, 2011, the S&P 500 Index is up 15% while trailing earnings rose only 1.7%, even with the Apple train contributing spectacularly. The resulting increase in PE multiples has brought PE’s to 14.5x, a touch below their long term average of 15, something which many bulls use as a reason to buy stocks even though not really an appealing discount.

The Rule of 20 valuation approach is certainly more inviting. With inflation at 2.9%, it states that fair PE is 17.1x which, on trailing earnings of $96.42 gives a fair valuation level of 1650 on the S&P 500 Index, nearly 18% above current level.


The inflation variable in the equation does not seem dangerous at this time. But the earnings side is more worrisome.

  • imageS&P 500 sales trend is closely correlated with nominal GDP growth (chart from JP Morgan). Sales grew 7.9% YoY in Q4, down from 10.4% in Q3. Another slowdown appears likely.
  • Profit margins peaked at 9.5% in Q3’11 and declined 8.4% to 8.7% in Q4. Given their already steep level and rising unit labor costs, the most likely trend is down.
  • The consensus estimate from S&P for Q1 EPS is $23.77, essentially unchanged from Q4’11 and up 5.4% YoY, a deceleration from +8.2% last quarter, +5.5% ex Apple.

These expectations look reasonable to me but investors may be disappointed if earnings only meet expectations. Barron’s last week warned:

As the first quarter comes to a close, companies in the Standard & Poor’s 500 index have warned in 81 instances that profits per share will fall below prior estimates, while they raised their outlook 28 times and said earnings should fall in line in 10 cases.  The ratio of negative-to-positive pronouncements hasn’t been that high since the first quarter of 2009. (Barron’s)


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.

That was at 1367 on the S&P 500. At the current 1399, the upside to 1650 is 18% and the technical downside on a correction to the 200 day m.a. (1270) is 9-10%.

I am no technician but most of the basic indicators I follow have recently broken down as the 1400 level is proving a thick wall on the eve of earnings season.

Given the state of the Eurozone, the continued weak trend in China and my relatively pessimistic analysis on the U.S. consumer (FACTS & TRENDS: The U.S. Consumer About to Retrench), I expect economic news to err on the negative side during the next several months, prompting investors to remain cautious, even more so with the U.S. elections approaching, and the U.S. fiscal cliff just on the other side.

For these reasons, I sense that it is unlikely that markets will reach “fair valuation” (1650) within this complicated context. A repeat of last spring is more likely: in April 2011, the S&P 500 came within 10% of the Rule of 20 fair value before correcting (18%!). If 90% of fair value is all we can hope for, that’s 1485, less than 10% above the current level.

Given the “technical gap” which might get aggravated by disappointing earnings, 10% upside does not provide a good risk/reward ratio.

The yellow flag if raised.


Note: if you own Eurozone equities, I hope it’s not based on current consensus estimates. See this chart from ISI. How lucky do you feel?


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