The S&P 500 Index is up 15% from its November 16, 2012 low of 1347 and 7% from its January 2, 2013 low of 1447. It needed 6 weeks to make the first 100 points but 10 weeks to book the next 100 points.

If you believe the media and many talking heads, now that equity indices are back to their previous highs, the economic, financial and even the psychological environments have finally cleared up for equities. So why is it that equities are advancing at a slower pace rather than roaring up given all the anxiously awaiting liquidity out there?

Try earnings! Trailing 4-quarter earnings for the S&P 500 Index peaked in August 2012 at $98.69. After the end of Q4’12 earnings season, they stand at $96.81. Forget all the esoteric mumbo jumbo from economists and strategists about why equities do this or that. Only two things matter: first and foremost: earnings. Second: P/E multiples.

Earnings are the easy part, as long as you use trailing, reported earnings and not pie-in-the-sky estimates. When trailing earnings are rising, it is like trout or bass fishing: if the fish is there, he will take the bait, voracious as these species are. The S&P 500 Index is up 110% from its February 2009 close. Surprise, surprise, trailing earnings are up 112% during the same period! The food was there, the voracious fish showed up and fed on it.


So much for the so-called Fed-fed equity markets.

However, when earnings stop rising, like they have since last fall, investors morph into Atlantic salmon anglers, trying to entice salmo salar to take a fly at a time when, just back from an ocean journey, he totally stops feeding when he enters his native river to spawn.

That is no easy fishing. Landing the right fly at the right spot, atop a resting salmon, is but the first step in the process. Will he decide to leave his comfortable lie and rise toward something that has no feeding appeal?

Usually, a salmon that leaves his lie does it deliberately, darting toward the fly even though he may not necessarily take it upon closer scrutiny. If he spares the fly, the angler’s spirit remains high since he knows that he’s got a keen fish. He shall rise again. He might take the next time. Or the next time.

(Painting from Mark A. Susinno)

However, there is that other kind of rise where the anxious fisherman watches the fish lazily leave his lie and rise, ever so slowly, on a path only suggesting a possible encounter with the fly. Such unmotivated salmon is in no rush. He slowly winds his way up as the angler tightens up, silently praying behind clenched teeth and mentally pulling the fish toward his fly. His nerves can barely take more when the slow riser finally nears the perfect bait. Even an experienced fisherman will shiver in anticipation, knowing too well that slow risers are not good takers. More often than not, they just swim along, snobbishly making their way back to their cozy lie. Bloody teasers!

This market is a slow riser. The growing earnings that attracted the voracious species since 2009 have disappeared. This market is an Atlantic salmon needing no food, wanting no food, totally focused on the job to accomplish upriver. He has swum upstream, against changing currents, leaping rapids and jumping chutes. He now wishes to rest, occasionally showing faint interest but really only loosening up.

When earnings stall, only rising multiples will lift equities up. This is when the so-called fishing experts show up with their theories about salmon fishing. This lore is infinite. It is often revealed like if it were conventional wisdom among the initiates, wisdom that normal people are ill-equipped to really comprehend.

The simple and objective Rule of 20 says that fair P/E equals 20 minus inflation, currently 1.6%. Fair P/E is thus 18.4 which, on trailing EPS of $96.81 gives a fair market value of 1781 on the S&P 500 Index, 14.6% above current level. In the chart below, the thick black line represents Trailing P/E + Inflation (16.0 + 1.6 = 17.6) while the thick horizontal red line is “20”. When the black line intersects the red line, the S&P 500 Index is at “fair value” and the blue line (S&P 500 Index) touches the yellow line (S&P 500 Index fair value).


The Rule of 20 provides a simple and objective way of assessing risk and reward for equity markets. It is not a forecasting tool since even a casual look at the chart shows that equities spend little time at fair value. They fluctuate around fair value generally within a range of 15 and 25 on the Rule of 20 scale. The chart helps visualize the risk/reward equation while the Rule of 20 provides objective calculations of the upside or downside to fair value.

The S&P 500 Index is currently in the lower risk area, where it has been since early 2009. At 17.6, the upside to 20 is 14.6% (1781) and the downside to 15, the low end of the 15-25 range, is -16.5% (1297), a balanced risk/reward equation. If earnings and inflation stay constant, this is what an investor needs to know before committing more or less of his own money to the stock market. Yes, markets can rise beyond fair value and give even better upside but that would be accompanied with meaningfully higher risk levels.

At present, earnings have stabilized and, if current Q1’13 estimates are right (!), trailing EPS will rise to $98.12 by next June, 1.4% above the current level. The $25.55 estimate for Q1 has stopped declining in recent weeks but obviously needs close monitoring. It would break the declining trend of the last 2 quarters.

Analysts are generally not the most dependable forecasters as we know. Add the weakish U.S. economy, its unstable politics driving unstable fiscal policies, the ongoing recession in Europe, the Chinese slowdown and the related fluctuations in commodity prices, the wild movements in forex markets and the increasing pension expenses booked by corporations and you begin to understand that relying on rising earnings is like betting that the slow riser will take the fly. Good luck!

As to inflation, It has declined from 2.2% in October 2012 to its current 1.6%. Actual CPI has remained unchanged since September. Core CPI is +1.9%, unchanged for the last 6 months. It is +2.0% annualized in the last 3 months. The threat of a meaningful acceleration in U.S. inflation is not great at this point.

Stable earnings, stable inflation. Only higher P/Es will lift this market. That necessitates higher investor confidence. Wanna hear my fishing stories? No, but my daily New$ & View$ posts now include a “Sentiment Watch” feature precisely because this needs close monitoring.

Meanwhile, monitor the slow riser. It would not take that much of an advance to tilt the risk/reward equation clearly to the risky side. For instance, the S&P 500 Index at 1600, only 3% higher, would mean 11% remaining upside against -19% downside, almost a 2 to 1 ratio. A decline to the Rule of 20 “15” level can happen quickly. Exactly one year ago, the S&P 500 Index tanked 10.6% from 1422 to 1271 within two months, even though earnings were still climbing and inflation waning.

How about the “new bull market” now touted by many?

One, we would need rising earnings and/or declining inflation. In such cases, the Rule of 20 “fair value” would be an upwardly moving target. See how the yellow line on the chart above has flattened out since July 2012 under stalling earnings and stable inflation. The target is no longer moving. As anglers know, a still fly is not an enticing lure. Whether earnings resume ascendency any time soon is pure conjecture that only talking heads and stock brokers can predict repeatedly without being definitely thrown out of town.

Slower inflation could, in theory, do the trick. However, that would presumably be the result of even weaker demand and pricing power, potentially hurting revenue growth and/or profit margins.

Two, investor enthusiasm could become such that valuation gets into dangerous levels. That has not happened since September 2007. In December 2009, the S&P 500 Index momentarily hit the Rule of 20 “fair value” level. Strongly rising earnings, slower inflation and a 7.5% market drop quickly restored valuation back to the Rule of 20 “15” low level.

The current environment is not conducive to unbridled enthusiasm. While central banks keep flooding the world with liquidity, politicians continue to sustain economic and fiscal uncertainty, preventing corporations, consumers and investors alike from seeing clearly what could lie ahead.

Salmon fishing season is only three months away. Remember, these slow risers are fickle. They may give you trepidation during their slow way up but they can turn back down for any reason, logical or not! Make sure you carry some floating device.


One thought on “THE SLOW RISER

  1. Interesting, but can we really believe inflation is at 1.6%. Given the ‘massage’ to what goes into this number over the last several years, this number severely under-reports actual inflation.

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