(Part of the background economic analysis can be read here).

GLOBALThe S&P 500 closed at 1278 last week, down 8.7% from 1400 when I raised the yellow flag on April 5 (EQUITIES: MIND THE GAP!) and again on April 30 (EQUITIES: YELLOW FLAG WAVED HIGH). We are now right on the 200 day m.a. (1286) which is still rising. More importantly, equities are now 27% below fair value (1765) under the Rule of 20, slightly worse than in the summers of 2010 and 2011. (Chart on right from WSJ)


As the chart above shows, fair value has continued to rise along with trailing earnings and declining inflation rates. Seems like perfect timing.

The Problem with Earnings

On March 3rd, 2009, right at the apex of the financial crisis, when superficial analysis said that equity markets were expensive (666 on the S&P 500!), I explained how the huge losses of some tiny capitalizations were severely distorting earnings and, thus, PE ratios.

At the extreme, and we are admittedly in an extreme period, a large company with a tiny market capitalization could incur losses so large as to wipe out most of the S&P 500 earnings (AIG lost over $60 billion last quarter alone). As a result, the Index PE would skyrocket even though the other 499 stocks’ valuation would actually not change at all. In effect, a casual or superficial observer looking at the Index would conclude that equities are expensive or overvalued when, in fact, 499 stocks would be cheap or undervalued.

We now seem to be at the other, though admittedly milder, extreme. Today, Apple is a large cap stock with skyrocketing earnings that are distorting total S&P 500 earnings. From my May 14 post BOTTOM FISHING? BUT WHERE’S THE BOTTOM?

Apple 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.

Official S&P 500 earnings for Q1 are $24.21 bringing trailing 12 months EPS to $98.09, up 1.7% from trailing EPS at the end of 2011. Ex-APPL, Q1 earnings declined 3.7%, after declining 9.2% in Q4. Trailing EPS ex-APPL actually declined 0.5% in Q1.

Looking into Q2 estimates, total EPS are now seen at $25.54 but ex-APPL the estimate is $22.97 and still eroding. Trailing EPS ex-APPL would thus come in at $91.28 in Q2, down 1.2% QoQ.

Also, negative-to-positive earnings forecasts given by companies for the second quarter – at about 3.4 to 1 – is the worst since the fourth quarter of 2008, Thomson Reuters data showed.

The breadth is unattractive as only Financials and Telecoms are showing a positive guidance ratio based on Factset data.

Factset also reveals another interesting twist to the Q2 earnings story:

For Q2 2012, the estimated earnings growth rate for the S&P 500 is 4.3%. At the sector level, the Financials sector is projected to have the highest earnings growth rate (56.9%) of all ten sectors and be the largest contributor to earnings growth for the index.

At the company level, Bank of America is by far the largest contributor to earnings growth for the Financials sector, mainly due to an easy comparison to a large loss reported in the year-ago quarter. The current mean EPS estimate for Q2 2012 is $0.18, relative to actual EPS of -$0.90 reported in Q2 2011. The large loss in the year-ago quarter was mainly due to a settlement related to Countrywide mortgage repurchase and servicing claims and other mortgage-related matters. Excluding Bank of America, the earnings growth rate for the Financials sector for Q2 2012 would fall to 10.7% from 56.9%.

Not only is Bank of America projected to be the largest contributor to earnings growth for the Financials sector, it is predicted to be the largest contributor to earnings growth for the entire S&P 500 at the company level (Apple is the expected to be the second largest contributor).

Excluding Bank of America, the earnings growth rate for the S&P 500 for Q2 2012 would fall to -0.5% from 4.3%.

Not only are Bank of America and Apple the largest contributors to earnings growth for their respective sectors, they are also the largest and second largest contributors to earnings growth for the entire S&P 500.

Excluding Bank of America and Apple, the earnings growth rate for the index would fall to -1.6% from 4.3%.

In my view, analysts are not through reducing their estimates. Global growth is slowing fast and the U.S. domestic economy is entering its own slowdown period. Moreover, Q1-2012’s labor productivity rose by a low 0.5% YoY, making it harder for companies to offset weakening top line growth. Bespoke Investment calculates that

For the S&P 1500 over the past four weeks, analysts have raised forecasts for 424 companies and lowered them for 598.

As I wrote in mid-March, the earnings tail wind for equities has stalled and it may be reversing.

Facts on U.S. equities can thus be summarized as such:

  • 27% undervalued based on the Rule of 20.
  • Earnings have stalled and may be declining.
  • Inflation is slowing, potentially offsetting declining profits as per the Rule of 20.
  • Absolute PE on trailing EPS is 13.0, historically on the low side.
  • Corporate America is in solid financial position with high margins and cautious cost control.

Since 1956, there have been 7 periods when the Rule of 20 showed undervaluation of 25% or more:

  • September 2011 (-23%): the S&P 500 rose 24% during the next 6 months.
  • August 2010 (-24%): +27% for next 8 months.
  • December 2008 to August 2009 (-24% to -41%): +32% for next 17 months.
  • August to December 1988 (-23% to -26%): +35% for next 16 months.
  • December 1981 to November 1985 (-25% to -43%): +170% during 68 months.
  • August 1976 to February 1979 (-25% to -42%): breakeven for the period.
  • February 1958 (-24%): +49% during following 17 months.

In all cases but the 1976-79 period (breakeven for the period), it paid handsomely to buy equities “at the sound of cannons”, even when undervaluation persisted and deepened.

What about the earnings risk? Can equities rise if earnings decline? Yes they can:

  • April to November 1938: EPS -30%, S&P 500 Index +33%. (Recession May ‘37-June ‘38)
  • March 1951 to June 1952: -17%, +13%.
  • March 1956 to October 1958: -22%, -17% (trough in December 1957). (Recession Aug. ‘57- Apr. ‘58)
  • September 1959 to June 1961: -12%, +14%. (Recession Apr. ‘60-Feb. ‘61).
  • December 1966 to September 1967: -4.5%, +21%.
  • August 1969 to December 1970: -12.6%, -24% (trough in June 1970). (Recession Dec. ‘69-Nov. ‘70).
  • September 1974 to September 1975: -14.8%, +31%. (Recession Nov.’73-Mar.’75)
  • March to September 1980: -4.3%, +23%. (Recession Jan–July 1980).
  • November 1981 to December 1982: -16%, -15% (trough in July 1982). (Recession July ‘81 – Nov  ‘82)
  • December 1984 to December 1985: -4.9%, +26%.
  • June 1989 to December 1991: -24.4%, +12% in first 12 months, -15% during following 4 months, total -4% for period). (Recession Jul ’90-Mar ‘91)
  • September 2000 to December 2001: -32%, -26% (trough in September 2001). Recession Mar ‘01-Nov ‘01)
  • June 2007 to November 2008: -37% (normalized), -40%. (recession Dec ‘07- June ‘09).

Of course, sometimes the market had already declined in anticipation of a recession, but not always. The point here is that markets can rise while earnings are in a declining trend. It happened in 7 of the last 13 times. Importantly, in all 7 cases, inflation declined along with EPS. Remember the Rule of 20: Fair Value = trailing EPS x (20 minus inflation). A 1.0 decline in the inflation rate offsets a 5% drop in trailing earnings.

Total and core CPI are both +2.3% YoY in April. Core has been rising at a 2.1% rate in the past 4 months but total CPI was unchanged in April and May-June will likely benefit from lower energy prices. Recent U.S. PMI reports indicate that there is little pricing power among manufacturers at this time while costs pressures are subdued by the global economic weakness. In addition, the U.S. dollar has been rising smartly in the past year.  In all, the outlook is for the CPI to trend lower in coming months.


We could well be about to get a big equity rally. Fear is extreme and visibility is very low, explaining the very attractive valuation. Normally, this is the time to close your eyes, pinch your nose, take a deep breadth and buy stocks.

It may be my age, or the fact that the salmon fishing season begins shortly but, for now, I’d rather be safe than sorry. I am sticking with an income and return of principal theme, not increasing equities overall.

Here’s why:

  • The game of chickens being played in Europe is too complicated with stakes and repercussions beyond understanding.
  • There is clearly a general bank run in Europe, not only from South to North but now from Europe to Switzerland and the U.S. Where and how that ends up is impossible to forecast.
  • The Eurozone economy is shrinking at an accelerating pace and complicated politics is in the way of most solutions.
  • This eventually has to impact corporate America which derives 45% of its revenues (S&P 500) from abroad.
  • American politicians are playing their own game of chickens. Based on recent experience, investors are unlikely to enjoy the spectacle of these headless hens fighting their ways towards stupidity supremacy before taking everybody down the fiscal cliff they have created.
  • All this while the U.S. economy is weakening, never having recovered from the previous downturn.
  • China has its own political intricacies while its economy is “surprisingly” weaker than expected.

Central bankers are watching the games of chickens, shouting advices in ways never heard before, warning the chicks that the Banks are running out of tricks to meet the swelling challenges. Should we bet on Bankers being heard, and listened too?

If this is the only hope, I’d rather go fishing peacefully. Bankers often also require visions of Armageddon before acting.

I have bought equities in March 2009, and in the summer of 2010 and again in August 2011 when undervaluation was also extreme due to the difficult economic and financial environments. This time, the economic challenges around the world are amplified by the complex (Europe), self-centered (U.S.) and intricate (China) political complications.

Stocks are very attractive, but the environment is too toxic. This chicken is willing to leave money on the table until he feels safer. Better be safe than sorry.



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    again thank you

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