BOTTOM FISHING? BUT WHERE’S THE BOTTOM?

S&P reports that, with 93.4% of the S&P 500 companies having released Q1 results, 66% beat and 24% missed. In effect, 1 in 4 companies missed severely reduced estimates in Q1. Interestingly, the last 2 weeks have seen the beat rate decline spectacularly with only 58% of companies beating estimates and 38% missing them.

S&P now estimates Q1 earnings at $24.17, up 7.1% YoY but down from the $24.33 estimate at April 30th. Trailing earnings are now $98.05. up 1.7% in the quarter.

A sectorial breakdown reveals that only 3 sectors reported above average earnings growth: Industrials (+20.0%), IT (+15.9%, all from AAPL) and Health care (+8.3%). Of the remaining 7 sectors, 3 recorded earnings declines and 2 had earnings growth below 2%. imageSales grew 6.6% overall and operating margins were essentially unchanged at 9.02%. However, 5 of the 10 sectors realized lower margins YoY in Q1. Only Industrials, Financials (lower loan loss provisions) and IT (Apple) saw strong margins expansion in the last 12 months.

Estimates for Q2 continue to be trimmed as the chart from S&P’s Howard Silverblatt shows. They are now $25.82, down from $26.01 at the end of April.

THE APPLE EFFECT

imageApple contributed $2.75 to S&P 500 earnings in Q1, up from $1.44 in Q4’11 and from $0.66 in Q1’11. Ex-Apple, Q1 earnings of $21.42 are down 2.1% YoY and down 3.9% QoQ, the second consecutive quarterly decline. Importantly, trailing 4Q earnings ex-Apple are down 0.5% from their level one quarter ago and are expected to decline another 0.9% in Q2’12.

Apple is a truly extraordinary phenomenon which, while not unduly impacting market valuation, is obviously boosting index earnings, masking the underlying weakening in America’s earnings power.

Trailing operating earnings are the only dependable fuel for equity markets, generally dictating direction, while the earnings multiple impacts amplitude. Trailing EPS had peaked at $91.47 in June 2007 and troughed at $39.79 in mid-2009, rising uninterrupted for the following 30 months. Equity markets followed the trend with their customary fear and greed fluctuations.

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According to Factset, 68 companies have issued negative EPS guidance for Q2 and 36 companies have issued positive EPS guidance. The breadth is unattractive as only Financials and Telecoms are showing a positive guidance ratio.

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At 1340, the S&P 500 Index is trading at 13.7x trailing EPS. U.S. inflation is 2.7% YoY, and core inflation is at 2.3%, 1.8% annualized since December 2011.

The dependable Rule of 20 valuation method puts fair PE at 17.3x (20 minus inflation), and fair index value at 1700, 27% above current levels! This is without a doubt a very cheap equity market. As the chart below shows (click to enlarge), buying U.S. equities at the current rare low valuation levels has always been very rewarding to the patient investor. It has certainly been true in March 2009, summer 2010 and summer 2011.

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Are we re-living the springs of 2010 and 2011 when markets tumbled 15-20% before recovering to higher levels? Unfortunately, the answer is yes…and no.

Yes, because the macro conditions are pretty similar: the economic and political landscapes in North America, Europe and China are as clear as thick mud. Investors are understandably highly uncertain as to how things will evolve in the next 6-18 months.

No, because fear is already everywhere and is largely reflected in equity valuations. In the springs of 2010 and 2011, the S&P 500 was selling at less than 10% undervaluation compared to the current 21%. In this regard, the downside risk looks less scary.

Excluding the March 2009 low point, the highest discount to fair value seen in the last 25 years is 24% in June 2010. That would be 1285 on the S&P 500 Index, some 5% below current levels and right on the rising 200 day moving average. A downside risk of 5% against a 25% upside is pretty appealing.

The problem, as I see it, is that, unlike the summers of 2010 and 2011, earnings have stalled. In fact, unbeknownst to most, they are now slowly declining as seen earlier. In a nutshell, the market sails are windless, currents are strong and treacherous and no capable rudder is in sight, wherever one looks.

The monetary tricks will continue but will they be effective? Bernanke’s QEs appear pretty tired. A U.S. recession would hurt earnings and the ensuing decline in equity prices would reverse the wealth effect right on the edge of the fiscal cliff. Draghi’s LTRO desperately needs a strong sibling, but what can we reasonably expect from this hugely dysfunctional family? Finally, China’s economy looks weaker by the day. Despite its economic and political opacity,  more and more glimpses of constraints and blunders  are becoming apparent. In any event, China cannot re-start Europe and/or boost the U.S. economy.

The Rule of 20 increases fair value when inflation slows. This time around, slower inflation triggered by slower world demand could well revive deflationary fears.

Money hates uncertainty. There’s so much of that now that we should all remember that it’s better to be safe than sorry!

Time to prepare for the fishing season, but no bottom fishing yet!

 

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