The way I approach equities is pretty simple and rational: I first look at the valuation facts provided by the time-tested Rule of 20 valuation method. Are equities cheap or expensive on the basis of trailing earnings and inflation rates? Most of the time, this is enough, as equity markets have this tendency to cycle through cheap and expensive territory in a pretty regular fashion. Once valuation facts are established, I look at the overall environment to assess how investor sentiment is likely to evolve and weather I can see a trigger that will unlock the cyclical forces and move equities toward their next valuation level.
The black line in the chart below provides a good visual of the valuation cycles since 1956 but you can go back to 1927 if you prefer (S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years). At a minimum, it should convince you of the need for a rational, patient, facts-based approach to equity investing (buy low, sell high!)
Equities have a general tendency to move from undervaluation to overvaluation in a pretty straightforward fashion, very much like economic cycles and greed and fear patterns. However, there have been a few periods when investors’ patience was truly tested like 2 years of cheap equities in 1959-60, many years of generally expensive equities in 1968-75, 4 years of very cheap equities in 1982-85 and 6 years of extraordinarily expensive equity markets between 1997 and 2002.
U.S. equities got extraordinarily cheap in early 2009, then doubled to fair value in early 2010, fell back to attractive levels in mid-2010, and almost reached fair value in the Spring 2011. They regained a cheap label in mid-2011 and have remained very cheap ever since.
Last April, I raised the yellow flag above 1400 on the S&P 500 Index arguing that the 18% undervaluation should be discounted:
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.
On June 6, I wrote BANKING (BETTING) ON BANKERS? with the S&P 500 at 1278 and concluded:
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. (…)
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? (…)
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.
We are now back to the Spring peaks of 1420 even though earnings have stalled, the world economic environment has significantly degraded and politicians are totally hopeless just about everywhere we look.
The truth is that cheap equity markets are always on the look for catalysts to unlock value.
Enters Super Mario with his uncanny ability to find, or at least speak his way out of the ECB regulations straightjacket. Since his famous late July words
“…the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”,
U.S equities have jumped nearly 7% in less than 3 weeks. Bernanke’s QE2 announcement lifted markets 7.5% in 2011 but his was an official and definitive announcement. Draghi’s words, up to now, remain only that, as they need the labyrinthine and often (always?) elusive translation-to-real-action from all kinds of political and regulatory bodies and committees with the E.U.
Interestingly, even though the S&P 500 Index is merely back to its early April peak, its valuation has improved from a 15% undervaluation to a 23% undervaluation. That is because trailing earnings have gained 2.4% since April and, importantly, U.S. inflation has declined from 2.7% to 1.4% as measured by the CPI. Under the Rule of 20, fair PE is 20 minus inflation so fair PE has increased from 17.3x to 18.6x, a 7.5% improvement.
Markets are presently hopeful that central bankers (ECB, Fed, BOE, BoJ and PBoC) will soon collectively and simultaneously manufacture and deliver all the financial heroin the world economies need to vaporize more than a decade of political, economic and financial stupidities into oblivion.
But the Rule of 20 is there to keep us rational and focused and it is shouting to buy equities. Look at the chart: 23% undervaluation (15.4 on the Rule of 20 scale) has very rarely happened in the last 80 years. What could go wrong?
- Earnings could start declining. After all, they seem to have stalled, being up only 2.5% YoY in Q2 and Q3 estimates lately being ratcheted down to a 0.8% YoY decline. Factsetreports that 76 companies have issued negative Q3 EPS guidance against only 20 positive.
- That said, my June 6 post detailed many periods when equity markets rose even though earnings were declining. However, in all 7 cases since 1938 where equities advanced against declining earnings, inflation declined along with EPS, further proof of the usefulness of the Rule of 20 which says that fair PE is 20 minus inflation. In effect, a 1.0 decline in the inflation rate offsets a 5% drop in trailing earnings.
- The problem this time is that inflation has already declined to pretty low levels, from 3.9% in September 2011 to its recent 1.4%. Further declines from here would bring us very close to deflation. The U.S. has experienced only 5 bouts of deflation since 1930, all but one (2009) having occurred between 1930 and 1955. Excluding the depression period of 1929-34, all other four periods of deflation began with deeply undervalued equity markets and ended up positively for equity investors, even though earnings declined meaningfully in 2 of the 4 instances (1938-39 and 2009). The other 2 periods, when earnings kept rising, were right after WWII and likely benefitted strongly from reconstruction expenditures in Europe and Asia.
- The big differences this time are that the intertwined world economies are all weak and still weakening (extremely weak in Europe), sovereign debt levels are extremely high and budget deficits are out of control. Moreover, political leadership is but a fading ethereal concept. In effect, world economies are being artificially sustained by central bank financial heroin which the world needs in ever rising quantities only to keep emitting surreal breathing sounds.
What to do? Given that the salmon fishing season is over for me, what else can I invoke to justify staying put in the face of hard evidence that the huge liquidity out there only needs a little push to pounce on cheap equities. Is Draghi enough of a pusher? Daddy, are we there yet?
Draghi’s gambit is bold and smart but remains hypothetical to this day:
- ECB intervention is conditional on countries such as Spain and Italy making formal request for EFSF/ESM help. Not a given, especially in Italy.
- The ECB seniority status remains to be dealt with. Not a given.
- How much firepower? What about the fact that Italy (18%) and Spain (12%) are supposed to contribute 30% of the EFSF funding? Who will backstop them?
Also, keep in mind that whatever the ECB does, its financial patch will do little to turn the economic tide which, to this day, remains very worrisome in Europe but also in the U.S. and in China. Ask the Greeks, the Irish and the Portuguese how their austere rescue packages have improved their lives in recent years. Recent PMIs keep flashing to a weaker outlook. If slower inflation, or deflation, is not accompanied by better economic trends, sales and profit margins would suffer.
The only potential game changer I see over the short term is a meaningful and sustained decline in oil prices which is not happening in spite of declining demand and increased Saudis exports. The Iran/Israel risk keeps world prices high enough for the Saudis to meet their budget but also for just about everyone else on the planet to miss theirs.
U.S. equities are very cheap but the hope rests essentially on closing the gap to fair PE while the earnings tail wind has quieted to a virtual standstill. Given the dire state of the world and so little political leadership, I’d rather bet on rising earnings than on rising PE’s.
The “R” word
Just about nobody is talking about the risk of a U.S. recession these days. Yet, the dependable LEI from the Conference Board is flirting with a recession signal as Doug Short’s great charts illustrate.
If bankers and politicians deliver, I might revisit but, for now, I remain cautious, and safe.