From the March 2009 market trough to the end of 2012, the S&P 500 Index has appreciated 114%. Perhaps just a coincidence but, meanwhile, trailing earnings have grown 116%. Yes Virginia, earnings matter!

However, as the chart below reveals (the chart is borrowed from ISI with my annotations in red), the various Fed QE programs have created much volatility within a profit-led bull market:image_thumb[5]

After the termination of QE1, the S&P 500 dropped 17% until the Rule of 20 P/E (black line on chart) reached 15.4 (15.0 is historically low); after QE2, it dropped 19% (Rule of 20 P/E of 16.3) and after Operation Twist, it lost 9% (Rule of 20 P/E of 15.1) until QE3 expectations lifted stocks again. At the recent high of 1691, the Rule of 20 P/E was 17.2. If fear reaches the same low points, the downside for U.S equities is 5-15% (1485-1595), or 0-10% from yesterday’s close of 1594. Interestingly, the 100 day moving average is 1578 and the 200 day m.a. is 1506.


Equities are admittedly not in the dangerously expensive zone and another shift in sentiment can occur anytime.

The problem is that unlike in 2010, 2011 and 2012, S&P 500 earnings have stopped rising. As I have warned several times this year, the earnings tail wind has disappeared, leaving equities at the mercy of currents. In the absence of any favourable political or economic currents, hugely strong monetary currents have helped steer equities up.

The Fed just warned that these will reverse as soon as the economic currents strengthen. But investors know that the economic currents can’t realistically reach the velocity of monetary currents. They have thus become wary of the announced crosscurrents and, understandably, are bringing some of their exposed fleets back in a safer harbour.

I still see no reliable sign that the U.S. economy is about to accelerate and I disagree with the Fed when it says that the risks to the economy are diminishing. Perversely, that might be read bullishly since it would extend QE3 well into 2014. Realistically however, corporate earnings may not be able to hold much longer in a 1-2% GDP growth environment, especially if inflation remains so low. This chart from Ed Yardeni supports cautiousness on this:image

With inflation at 1.4% and trailing earnings of $98.35, the Rule of 20 says fair value is 1829 on the S&P 500 Index (20 minus 1.4, times 98.75). The current 10% downside risk pales a little against the 15% upside to fair value. However, the environment remains such that it seems highly unlikely that investors will overcome the numerous uncertainties floating around and pay fair value for equities any time soon. I would rather wait to see how Q2 earnings come out. When sailing in strong crosscurrents, it is better to have a good, sustained tail wind. There is no such support now.


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