U.S. EQUITIES: POOR RISK/REWARD RATIO

The earnings season is almost complete. S&P reports that of the 446 S&P 500 companies that have reported, 65% beat estimates and 27% missed. As expected, the beat rate has diminished slightly throughout the season and the miss rate has gradually edged up to 27%. The miss rate has been rising steadily from 23.7% in Q3’12 to 24.8% in Q4’12 and 25.9% in Q1’13.

Q2 earnings are now seen at $26.43, in line with the $26.40 estimated at the end of June, and up $1.00 or 3.9% YoY, a deceleration from the 6.3% YoY growth rate recorded in Q1’13. Trailing EPS should thus come in at $99.35, up $1.00 or 1.6% from the previous quarter, a slight advance from the $96.82-98.69 range since March 2012, a period during which the S&P 500 Index rose 20.7%.

This is in contrast with the March 2009-March 2012 time span when equity prices doubled, pushed ahead by the strong tail wind of a doubling in operating earnings. The latest advance was purely a valuation increase toward the 1800 level, a level which the Rule of 20 has been qualifying as “fair value” since May 2012 (yellow line on chart). Notice how the Rule of 20 Value (P/E + inflation), the black line on the chart, has risen from 15.1 in May 2012 to its current 18.8, only 6% shy of the 20 fair value level.

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During the next 6 months, investors will be confronted with the following:

  • Trailing earnings have barely advanced during the last year and Q2 EPS only grew 3.9% YoY, thanks primarily to Financials. Ex-Financials, Moody’s calculates that Q2 earnings declined 1.3% YoY.
  • Ex-Financials, the YoY gain in quarterly earnings has averaged 1.4% since Q2’12. It has averaged +0.3% during the first half of 2013, down from +1.5% for the whole of 2012.
  • Revenues of non-Financials have grown 1.7% in Q2’13, up from +0.3% in Q1 but down from +2.1% for all of 2012.
  • Such a context makes it pretty difficult to readily accept analysts projections for the next 6 months. In fact, analysts keep shaving their second half estimates. Estimates are $27.17, +13.2% YoY, for Q3 and $29.13, +25.8% YoY. Please, don’t bet your life savings on these numbers. Earnings pre-announcements continue to be primarily negative. Factset reports that of the 85 companies that have pre-announced Q3 results, 68 companies have reduced guidance.
  • Moody’s says that revenue estimates for non-Financials are +3.5% for Q3 and +8.8% for Q4. This combination of expected accelerating revenue growth with rising operating margins makes the next 6 months highly prone to downward revisions.

All this in the context of a pretty sluggish economic background which keeps confounding most pundits, including the pundit in chief.

So, unless something resembling a magic wand helps boost earnings, equity investors will be navigating the present economic, financial and political cross-currents with no earnings tail wind while facing equity valuations that are only 6% shy of fair value.

This is the third time we get to this valuation wall since the bull market began in March image2009. Retreats were sudden and painful in spite of rising earnings and fairly stable inflation. As we approach the dangerous month of September, it seems appropriate to assess the gaps: A set back in the Rule of 20 P/E to 16, assuming stable inflation, would bring equities down some 15%. Technically, the 100 day m.a. is only 4% lower at 1625 but the 200 day m.a. is at 1545, 9% below.

What’s the upside against these risk measures?

Plus 6% to the Rule of 20 fair P/E of 20 (trailing P/E of 18.0 + 2.0% inflation). Beyond 1800, we get into the twilight zone where gurus of all sorts will no doubt find contextual or esoteric justifications for valuation levels which, while potentially lasting, inevitably lead to deep sorrows, unless, of course, key fundamentals such as earnings and inflation, start supporting higher prices again.

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Can extremely low interest rates support higher valuations?

Equities are not priced based on short term interest rates which are what the Fed normally controls. Longer term rates, used as a discount factor for cash flows and generally competing with equities for investor favour, do impact equity valuation. To the extent that long term rates reflect inflation expectations, using inflation as a proxy for a discount factor is appropriate in as much as it eliminates fluctuations in real interest rates and provides a more stable valuation tool, free of investor mood swings.

This time around, it seems even more appropriate to use inflation rather than long term interest rates. In effect, Bernanke’s gambit was to bring long term rates low enough to force investors out of fixed income into equities. During the last year, Bernanke’s bet paid off as reflected by rising P/Es during QE3 while profits stalled.

But as the market has begun to prepare and adjust to an eventual tapering by the Fed, long term interest rates have been rising toward more “market-derived” levels, more in line with “normal” real rates levels.

How this normalization process will take place is unknown, even to Fed officials. It is thus better to continue to use inflation as a discount proxy if one wants to keep investing based on solid fundamentals rather than on artificially set rates, the unwinding process of which is more akin to dice throwing than to educated guessing.

 

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