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.



We are two-thirds into earnings season. The stats are getting more meaningful, though not necessarily better.

S&P officially has 343 reports in, 65% beats and 23% misses. Importantly, estimates keep coming down. Q4’12 EPS are now seen at $23.53 ($23.83 last week), Q1’13 at $25.71 ($25.86) and Q2’13 at $27.53 ($27.62). The magic of rising markets and upbeat economic expectations is keeping full year 2013 estimates essentially intact at $111.36 ($111.50). That is in spite of the fact that Q4’12 earnings will be down 0.8% Y/Y and down 2.0% Q/Q.

IT companies are handsomely beating estimates (82%). Ex-IT, the beat rate drops to 62%. Ex-Financials (69% beat rate), the ex-IT, ex-Fin beat rate is 59.8%.

S&P 500 companies’ revenues are estimated at $285.43 in Q4’12, up 4.7% Y/Y, much better than the 1.1% growth rate in Q3 when 3 sectors had negative growth rates (Energy, Materials and Utilities).

Margins have finally declined, being expected to total 8.2% in Q4, down 46 bps Y/Y. A big part of the decline comes from higher pension expenses (see EARNINGS: Pensions Costs Begin To Bite) which many aggregators, such as Moody’s, seem to consider non-operating (wrong). What is interesting from Moody’s table below is that ex-Financials, earnings growth drops from 9.6% to 4.1%, although I fail to see how they got +9.6% in the first place.


To be sure, Q4 data is very messy, partly due to pension expenses, partly to volatile commodity prices. This table draws from S&P data and takes account of increased pension expenses.


S&P 500 Index trailing 12-month EPS are now seen at $97.20 after Q4’12, down from $97.50 last week, and from $97.40  three months ago. As I wrote recently, the reality is that quarterly earnings have been stable since Q2’11 and trailing 12-month EPS peaked in Q2’12. To repeat myself:

Equity values have little back wind to advance “naturally”, unlike 2009-2012 when earnings were rising sharply and inflation declined. Until earnings rise again, equities need investor enthusiasm if undervaluation is to be narrowed, a pretty fickle ingredient if there is one.

The undervaluation of the S&P 500 Index is currently 15% as the Rule of 20 fair value is 1778. The 1500 barrier has been traversed and we are within sight of the 2007 peak of 1570 which will undoubtedly excite the talking heads.

By the way, if you care (I only do because he has been a pretty good contrary indicator), Nouriel Roubini tags equity markets as “rightly buoyant”:

“When you look at the [mixed] economic data, there’s a gap between the fact that the markets, rightly so, are buoyant,” he told the network, “because middle of last year central banks had done another massive round of quantitative easing.” (CNBC via

The über-bear ZeroHedge never misses a moment to ridicule bullish talking heads:

Six years ago today, with the S&P 500 around 1460 – having risen 20% without a correction for seven months – a handful of Wall Street’s best and brightest joined CNBC’s Larry Kudlow and Bob Pisani to discuss the Goldilocks economy, why the bears are wrong, and where the market is going next. Sometimes, we just need a reminder to snap us out of that recency bias… for example, Bob Pisani: “We have got a global rally going on… and the important thing is… there’s a floor to the market – every time, for the last seven months, they sell the market down for 2 days, it comes right back.”

Ralph Acampora: “I’m bullish, but I don’t think I am bullish enough…there’s new leadership”

Larry Kudlow: “Goldilocks kicks some more butt and the bears of the last four years are wrong… as they climb the ‘wall of worry'”

Bob Pisani: “Transports have been rallying – as the disaster that the bears keep talking about hasn’t happened… When you are in a global expansion like this, to sell…is foolish.”

and our favorite:

Bob Pisani: “People who keep talking about this real estate bubble don’t understand… there are 3 things that bring down real estate markets: 1) the economy falls apart, 2) liquidity is withdrawn, and 3) supply overwhelming market – NONE of that has happened.”

This is why we must always keep sight of both the upside potential and the downside risk.


Upside to fair value is +17%.

The first downside risk is technical: the 200 day moving average is at 1405 (-7.4%), but rising. The second risk is that deep pessimism returns and undervaluation retreats to the mid-2012 level of -25% (1333, -12%), not totally unlikely given the many economic uncertainties remaining, the difficult financial situation in the U.S. and Europe and the messy politics just about everywhere.

Some may find comfort in the fact that analysts remain upbeat with Q1’13 estimates +6.1% Y/Y. Expected growth is accelerating smartly as the year progresses: +8.3% in Q2, +18.1% in Q3 and a whopping +26.3% in Q4. Equity markets can feed on these hopes for a while but there is ample room for disappointment.

Indeed! Factset reports that:

In terms of preannouncements, 63 companies have issued negative EPS guidance for Q1 2013, while 17 companies have issued positive EPS guidance.

Let’s see the trend this earnings season:


It is important to realize that flattish earnings provide little backstop if investor sentiment turns down. Much like a windless sailboat seeking strong currents to move along, equity markets now need higher multiples to advance, a bigger bet than when earnings are fueling the engine. For now, investors seem hopeful, encouraged by:

  • a better housing market;
  • better employment numbers;
  • accelerating bank loans;
  • better news from China;
  • better second derivatives from Europe.

Yet, sentiment can change overnight. Consider these mood changers:

  • the ongoing fiscal drag hurts spending;
  • higher oil prices hurt spending;
  • the sequester hurts spending;
  • Europe keeps sinking;
  • U.S exports get hit;

The five positives are well known; the five potential negatives are not.

The 17% upside potential still outweighs the -7% technical downside risk more than 2:1 (assuming sentiment stays reasonably good…). Interestingly, under current conditions, at 1570 the upside to fair value would be 13% while the technical downside would rise to 10%. Such more balance risk/reward ratio could be a strong barrier.

I am keeping my equity light green, for now, but I am getting more nervous, carefully watching the current.


EARNINGS: Pensions Costs Begin To Bite

Last Monday, I posted an update on equities, keeping the green light on because of valuations but warning that

equity values have little back wind to advance “naturally”, unlike 2009-2012 when earnings were rising sharply and inflation declined. Until earnings rise again, equities need investor enthusiasm if undervaluation is to be narrowed, a pretty fickle ingredient if there is one.

The recent market advance coincided with generally positive Q4’12 earnings reports amid more encouraging economic and financial news.

Yesterday, I checked with Standard & Poor’s to see how earnings estimates are behaving given the good beat rates. To my surprise, Q4’12 estimates actually dropped 5.3% in S&P’s latest tally, from $25.18 to $23.84. I queried S&P’s Howard Silverblatt who explained that some special items “which are not really special” were included in operating earnings. But more importantly,

Several companies have changed the accounting method they use for pensions, and more are expected to do so.  Currently most companies average their pension portfolio returns over several years.  The idea is that the ‘smoothing’ takes some of the volatility out of the returns, as well as out of earnings and the balance sheet.  Good idea, but the problem is that it also makes it difficult to see the actual results and impact.  The smoothing permits some companies to report gains in Bear markets, and losses in Bull ones. 

So, some companies have changed the process to a mark-to-market type of accounting, booking what they make, or loose, in that period.  The initial adjustment typically is a large charge, as the carrying value and costs of pensions come into line with today’s evaluations.  Companies say this makes their reporting more transparent, and I agree.  It also makes earnings more volatile.  If the market shifts, the full change in their portfolio will be seen in the earnings and balance sheet.  And, when interest rates do finally increase, maybe some time in late 2014 if all goes well, their discounted pension liabilities will significantly decrease, reducing their pension deficit. 

(…) some of the changes are impacting Q4 earnings.  S&P treats pensions as a normal part of operating income, and includes the gains and losses in their earnings; others do not totally agree, and exclude the impact.  Therefore S&P’s Q4 2012 EPS are lower than some of the others on the street.  (…)

Pension costs are obviously operating costs and we knew that at some point companies would need to adjust their pension expense upward. I use operating earnings in my valuation work because it is more appropriate than reported earnings and I respect S&P’s consistent and sensible methodology.

Analysts have few tools to assess pension costs and CFOs tend to provide little guidance on these. We should therefore probably expect more surprises and greater volatility in future years earnings. We need to monitor the trends even more carefully.

  • Only 41% of S&P 500 companies had reported at the last S&P update (Feb. 24). More pension surprises coming?
  • Q4’12 estimates have declined 5.3% but Q1’13 and full 2013 estimates have not budged, yet…

For now, I must remain consistent and reassess the risk/reward ratio: given current Q4’12 estimates, trailing 12 months earnings would come in at $97.51, 1.4% lower than last week’s estimated level. The upside to the Rule of 20 fair value is shaved to 18.5% as a result. Not a big deal but there is a risk of further downside revisions in coming weeks that recent good beat rates were not suggesting might be coming.




The equity light is green but look around before you seriously commit!

NYC Pedestrian Dangers

For eight consecutive trading days, the Standard & Poor’s 500-stock index has edged higher—always by less than a percent—the longest string of gains since 2004. On Friday, it cleared a new milestone, closing above 1500 for the first time in five years.

  • And it did so despite the sour performance of poor old Apple as its magical iPhones came up with the wrong numbers. (Barron’s)
  • Earnings exceeded projections at about 76 percent of the 147 companies in the S&P 500 that have released results so far in this reporting season, while 67 percent topped sales estimates, according to data compiled by Bloomberg.
  • Of the 134 companies that have reported earnings to date for the fourth quarter, 69% have reported earnings above estimates. This percentage is equal to the average of 69% recorded over the past four quarters. The Information Technology (84%) and Materials (80%) sectors have the highest percentages of companies reporting actual earnings above estimates. In terms of revenues, 64% of companies have reported sales above estimates. This percentage is well above the average of 50% recorded over the past four quarters. (Factset)

Equities are rising right in the middle of the earnings season. This focuses the media on the single most important factor in equity valuation: earnings. S&P, the official benchmark, currently sees Q4 operating earnings at $25.18, up 6.1% Y/Y and + 4.9% Q/Q.

Supported by the ample liquidity supplied by central banks, low interest rates, stable inflation and generally encouraging economic data, better than expected earnings, even after their downward revisions of the past months, are driving equity prices higher. This is what happens generally when low valuations get support from rising investor sentiment backed by improving basic fundamentals. Earnings are nowhere from booming, but they are not collapsing as many feared, and the dreaded fiscal cliff is now regarded as a mere bump on the road.

The media have been much jollier recently as the U.S. and China have shown improving economic data while Europe seems to have stopped sinking. Money has started to flow into equities while investment “gurus” and other talking heads become more optimistic. For some strange reason, it has suddenly become in to be bullish. A return to all-time highs after a 125% rise in prices likely triggered this new fashion statement.

image_thumb[5](Chart from Ian McAvity)

The fact is that quarterly earnings have peaked in Q2’11, right at the $24.06 peak of Q2’07, and have only been going sideways since:


Estimates now call for a break out to $26.25 in Q1’13, rising steadily to $29.72 in Q4. We shall see if that proves optimistic, as it usually does. Here’s what Factset said Friday:

Corporations and analysts have begun lowering earnings expectations for Q1 2013. In terms of preannouncements, 28 companies have issued negative EPS guidance for Q1 2013, while just four companies have issued positive EPS guidance.

In mid-2011, when quarterly operating earnings peaked, the S&P 500 Index was in the 1300 range, 15% below its current level. However, U.S. inflation has dropped from 3.5% to 1.7%. Under the Rule of 20, such a decline in inflation warrants a P/E boost of 1.8, from 16.5x to 18.3x, an 11% valuation gain.

Trailing EPS could reach $98.85 when Q4 results are all in, a 2.5% increase over 12 months and only 1.5% ahead of their $97.40 level after Q3. Given inflation at 1.7%, fair P/E is 18.3x for a Rule of 20 fair index level of 1808, 20% above current levels!

When I turned the equity light to green on December 18, 2012, the S&P 500 Index was 25% undervalued based on the Rule of 20 with a technical downside to its 200 day moving average of 3.3%. The fiscal cliff was still looming but the risk/reward ratio was very favorable when many important economic and financial catalysts were improving.


Currently, the upside to fair value is a still very appealing 20% but the technical downside has increased to 6.7% (200 day m.a. at 1400). The risk/reward ratio is still favorable but nevertheless somewhat less comfortable given the state of the economy and the political environment:

  • The economy is likely to remain sluggish and volatile, preventing a sharp earnings acceleration, especially since margins are elevated. Earnings guidance needs close monitoring.
  • The effects of the fiscal drags under way are unknown and they could be significant. The U.S. consumer is fragile and it remains to be seen if the so-called wealth effect stemming from rising equity and home prices can offset the harsh reality of a 2.7% hit on take-home pay.
  • The housing market recovery has finally reached front page status. Yet, diminished disposable income and tough mortgage rules are significant hurdles to a sustained recovery.
  • While housing (2.7% of GDP) gradually recovers, U.S. exports (14% of GDP) are slowing while signs of currency wars are increasing and widespread. Keep in mind that the U.S. dollar has depreciated nearly 33% against major currencies since 2002, 12% since 2007.
  • What will happen with the upcoming $1.2B sequester soap opera?
  • Effective corporate taxes are low and should be normalized somewhat until an eventual (?) tax reform is completed.
  • The political landscape remains murky at best while the huge fiscal challenge remains. President Obama is clearly on the offensive with his obvious leftist bias.

In 2010 and 2011, U.S. equities rose within 5% and 8% of fair value respectively before retreating under the uncertainties stemming from the Eurozone crisis and the U.S. political mess (look at the McAvity sentiment chart above). The road to fair value is thus not straightforward and far from a slam dunk. Close monitoring of the risk/reward ratio and of high frequency data is paramount at this stage.

One big difference from the 2010 and 2011 episodes is that risk aversion has since essentially disappeared in the fixed income market while increasing on equities, almost the exact opposite as in 2000. This is unsustainable as this National Bank Financial chart shows:


Fashion can lead people into unreasonable behavior. It was so fashionable to be bearish on equities in the late 2000s that most people totally missed the recent extraordinary bull market. Are we entering another period of euphoria where the U.S. becomes investors’ darling? After all:

  • The U.S. economy has become very competitive to the point where we may be into a “manufacturing renaissance”.
  • America is quickly becoming energy self-sufficient, boasting the world’s lowest natural gas prices (by a mile) and exploding oil production. Another game changer!
  • American companies have shown an uncanny ability to boost profit margins even in very difficult economic and financial conditions. Given the manufacturing renaissance and the energy game changer, corporate profits could continue to surprise on the upside.
  • Institutional and individual investors are so underweighted in equities that we may be at the beginning of the “great rotation” which would create strong demand for equities for many years to come.

Perhaps, but for now, curb your enthusiasm somewhat and remain cool:

  • Earnings have plateaued and are no longer rising. Let’s see how they do in 2013. Keep using trailing earnings.
  • Inflation has declined sharply to 1.7% Y/Y in spite of all the QEs, super QEs, LTROs and other central bankers’ printing tricks. Lower energy costs have been very helpful but core inflation seems stuck at the 2.0% level while the median CPI has been climbing a steady 0.2% per month for the past 6 months.
  • This means that equity values have little back wind to advance “naturally”, unlike 2009-2012 when earnings were sharply rising and inflation declined. Until earnings rise again, equities need investor enthusiasm if undervaluation is to be narrowed, a pretty fickle ingredient if there is one.
  • Politicians are very apt at moving sentiment and I suspect the next several months will provide them with ample opportunities to spur second thoughts in financial markets.

We must now become fashion watchers.

“Human beings desperately want to belong, but, they also desperately want to understand the environment around them. Often, the desire to belong and the desire to know the truth conflict. The idea of the majority view or the ‘mainstream,’ gives people the sense that they are a part of a group, and at the same time, gives them the illusion of being informed.”
Brandon Smith (via John Hussman)

The recent Barron’s is a good example of crowd teasing:


The Next Boom  Cheap natural gas and increasingly competitive labor costs are bringing factories — and jobs — back to the U.S. Eight ways to win.


It’s Gonna Be Delicious  Want a get-rich recipe? Start with our experts’ mouthwatering investment bargains in energy, retailing, banking, and more. Up this week: Abby Joseph Cohen, Brian Rogers, Oscar Schafer, and Scott Black.

John Hussman had a good piece this weekend (Capitulation Everywhere), complaining about his lonesomeness in bear country:

(…) The bears are gone, extinct, vanished. Among the ones remaining, many are people whom even I would consider to be either permabears or nut-cases. (…)

And capitulation is everywhere. CNBC ran a story last week “Bears on the Brink: I Can’t Fight It Anymore.” Even the normally staid Alan Abelson of Barron’s finally threw in the towel last week, abandoning his own caution that stocks have run too fast, too far, and suggesting that investors let their profits run “until they start to go the other way. After all, markets rarely fall out of a bed in one fell swoop as they did in 1987 and, more recently, the turn of the century, so there’s usually plenty of time to cut and run … we hope.” I suspect that Alan is actually gagged in a closet somewhere, and that someone is submitting rogue articles in his absence. Alan, I hope very much for your timely return. (…)

The equity light is green but look around before you commit! Over the shorter term, consider the following charts from Oakshire Financial before you blindly get fashionable. And keep good control of your portfolio beta.

Extraordinary.  We just witnessed the biggest net inflow into long only mutual funds since the height of the tech bubble in March 2000, and the fourth largest net inflow in history.


NEW$ & VIEW$ (18 DECEMBER 2012)


I am partly re-committing to equities after having been cautious since April 2012.

  • The S&P 500 Index is 25% undervalued based on the Rule of 20.
  • Earnings have peaked but are not collapsing like in 2007.
  • Inflation has slowed and seems unlikely to re-accelerate soon.
  • The U.S. economy remains ok. Avoiding the fiscal cliff removes a big short term threat. Christmas sales look ok.
  • Oil prices are not a big threat although Middle East tensions remain.
  • The Fed keeps pumping.
  • China is not hard landing, actually showing signs of re-acceleration.
  • Europe remains in poor shape but the ECB will act as a backstop if things get worse.
  • Technically, U.S. equities look good with stocks above the rising 100-day and the 200-day moving averages. Technical downside is 1390 on the S&P 500, -3.3% from the current 1438 level.
  • Not a slam dunk but, all in all, the risk/reward ratio is very favorable and many catalysts are turning positive.



Obama Tax Concessions Signal Potential Bipartisan Budget Deal 

New Offers Bring Cliff Talks Closer

The White House for the first time abandoned its effort to raise tax rates on income above $250,000, one element of its counteroffer to Republicans as both sides try to craft a deal before the end of the year.

President Barack Obama backed away from his long-standing call for raising tax rates on households making more than $250,000 a year, a development that inches the White House and congressional Republicans closer to a budget deal.

During a meeting with House Speaker John Boehner (R., Ohio) Monday the president proposed allowing Bush-era tax rates to expire for households making more than $400,000 in annual income, people familiar with the meeting said. (…)

As part of the offer, the president lowered the amount of tax revenue he is seeking in a deal from $1.4 trillion to $1.2 trillion. He also agreed to accept a GOP proposal to slow Social Security growth by using a different inflation formula to calculate cost-of-living increases, people familiar with the matter said. (…)

Pointing up Another notable change in the White House’s newest offer was the removal of a push to extend the payroll tax cut. The change means the amount of tax paid by virtually all earners next year will increase.

A Democratic official familiar with the talks said Mr. Obama’s offer could pass the Senate but would still be a “tough sell” within the party because of the Social Security proposal and the retreat from the $250,000 income threshold on tax increases.

Stocks Rise on Cliff Deal Hopes

European stocks, German Bund yields, oil futures and gold prices climbed amid signs of progress in the U.S. budget negotiations.


Sun  All 50 States Have Gas Below $4 for First Time in 2012  Gasoline prices have been falling for weeks, and have now reached a new low for the year.

The national average pump price of regular gasoline fell 9.2 cents a gallon last week to $3.248 a gallon today, the lowest price since December 2011, AAA Daily Fuel Gauge reports. Prices are still a bit higher than they were at this time last year.

Prices have fallen each day this month on rising supplies and are down 16% since mid-September




Sales jumped 4.3% last week, past their Thanksgiving week peak, to their highest level since April. The 4-wk m.a. is back to its September 15 level, up 3.3% Y/Y.




Smile  Power consumption growth rate hits record for 2012  China’s electricity consumption reached 413.9 billion kilowatt-hours in November with 7.6 percent growth year-on-year, a record high in 2012.

The commission said on Monday that it was the first time all provinces and autonomous regions realized positive growth in power consumption since April. The country’s electricity consumption increased 5.1 percent year-on-year in the first 11 months.

Smile  Chinese Housing Provides Cheer

A government survey released Tuesday showed that average housing prices in China rose at a faster pace in November from the month before, following largely marginal gains since June. Sales and investment picked up in recent weeks in part because of a growing perception that prices have bottomed out, analysts said.

[image]The data came after Beijing signaled a potential subtle shift in its nearly three-year-long property tightening campaign. Policy makers at a weekend meeting reiterated a pledge to crack down on speculative investment but conspicuously refrained from emphasizing the need to bring prices down. (…)

The Wall Street Journal calculations based on data released Tuesday by the National Bureau of Statistics showed that average prices in 70 cities polled increased by 0.24% on average in November from a month earlier, compared with a 0.05% increase in October. Compared with a year earlier, prices fell 0.6% on average in November, decelerating from a 1% decrease in October. Prices of newly built homes in 53 of the 70 surveyed cities rose in November compared with the previous month, more than the 35 cities in October.

U.K. Inflation Holds Steady  The annual rate of inflation in the U.K. held steady in November after accelerating in October, underscoring Bank of England concerns that price pressures will persist despite weak economic growth.

The Office for National Statistics said consumer prices rose 2.7% on the year in November, the same annual rate measured in October. Prices rose 0.2% between October and November. The annual rate of core inflation, which excludes volatile food and energy prices, also held steady at 2.6% in November, official data showed.

Riksbank Cuts Main Rate

Sweden’s central bank lowered its main interest rate, seeking to help overcome a drop in growth as European demand for Swedish exports slows.

Red rose  Wal-Mart Takes An Assault Rifle Off Its Virtual Shelves  America’s biggest gun seller is backing away from a now-notorious assault rifle on sale on its shelves, removing the weapon from its online catalogue. Peace


The Shiller P/E: Alas, A Useless Friend


The high level of the Shiller P/E is one of the bears’ main arguments against equities. Bulls claim that the 10-year average earnings it uses to measure P/Es is unduly depressing earnings because it includes not just one but two of the worst profit recessions in history, the bust and the financial crisis. They also generally prefer to use “operating” earnings as opposed to the “as reported” profits that the Shiller P/E approach favors. Three articles on that debate:

Shiller P/E advocates strongly dispute the more bullish arguments. Professor Shiller admits that “corporate earnings have been unusually volatile in the past decade” but he argues that this is more reason — not less — to use normalized earnings in calculating the market’s P/E.

Others simply dismiss the bulls’ arguments with more dogmatic, almost religiously radical statements such as:

  • What about the fact that the past 10 years include two major earnings anomalies that skew the market’s CAPE? “I’m grateful that there are people who believe that, who can be on the other side of my trades,” Mr. Arnott says.
  • In short, if you don’t like what Shiller is telling you, it is because you are a bull who thinks “this time is different”.

And the ultimate:

“What alternatives do people have?”

I am entering the debate because:

  • “Operating” earnings are a better gauge of index profits;
  • Assessing current indices against the last 10-year earnings is flawed;
  • Looking at past evidence, the Shiller P/E is simply useless as a market valuation tool;
  • There is at least one alternative.

When I began as a financial analyst, back in 1975, our clients were essentially conservative pension funds and wealthy businessmen. When companies reported year-end results, one of the first questions clients asked was “What are the operating earnings?”.

In those and previous years, accounting rules and regulations were so loose that accountants had much leeway in presenting results. Investors were shown but one set of results, often highly manipulated, which may or may not reflect previous years methods and/or competitors’ standards. You had to wait 4-8 weeks after the initial release for the annual report to be mailed. Only then could you delve into the details and the notes in order to decipher what were the “operating results”, pruning out of the “as reported” all the accounting noise that, more often than not, contributed positively to the reported results.

This annual exercise helped us better appreciate and adjust the quarterlies which often came on a small folded carton with no details other than revenues, certain cost items, if any, depreciation charges and taxes. The quarterly cash flow statements were “very useful” in providing total non cash charges that may, or may not, have arisen from normal operations.

One could then approximate how companies were performing on their basic operations in order to better evaluate their stock.

“Those were the days, my friend”.

Nowadays, many investors and “observers”, often in the name of conservatism, totally dismiss “operating earnings”, advocating the exclusive use of “as reported” earnings when valuing equities.

“The times, they are a-changin’”!

Accounting “principles” changed frequently throughout the 20th century. A case in point, the treatment of unusual or extraordinary items has been fraught with difficulty. Generally,  companies had preferred to place extraordinary bad news in the earned surplus statement, and extraordinary good news in the income statement. APB Opinion 9 in 1967 endorsed the SEC’s preferred all-inclusive income statement, although it said that extraordinary items should be reported separately. Under APB Opinion 9, companies simply began rationalizing good news as ordinary and bad news as extraordinary. In 1973, APB Opinion 30 established a “Discontinued Operations” section of the income statement and defined extraordinary so narrowly that the classification no longer existed as a practical matter. In 1974, FASB’s SFAS 4 designated gains and losses on the premature extinguishment of debt as extraordinary. In 2002, SFAS 145 rescinded SFAS 4.

Other contentious issues involved inventory costing (FIFO, LIFO, etc.), goodwill recognition and amortization, foreign exchange translation, pension costs, consolidation, just to mention a few.

Here’s how the American Institute of Accountants saw its role in 1933.

Within quite wide limits, it is relatively unimportant to the investor what precise rules or conventions are adopted by a corporation in reporting its earnings if he knows what method is being followed and is assured that it is followed consistently from year to year.

When advocates of “as reported” earnings claim that “operating earnings” are manipulated and that historical stats are purer, they take little account of the fact that historical earnings were themselves positively manipulated, often much more so, than modern “operating earnings”. At least, the latters are now much better defined and consistent and are more openly displayed.

It is only in 1973 that an independent FASB became the first full-time accounting standards-setting body in the world and began to gradually improve and standardize accounting rules.

Standard & Poors has data segregating “operating” and “as reported” earnings going back to 1988.

As Reportedincome, sometimes called Generally Accepted Accounting Principal (GAAP) earnings, is income from continuing operations. It excludes both discontinued and extraordinary income. Both these terms are defined by Financial Standards Accounting Board (FASB) under GAAP.

Operating income then excludes ‘unusual’ items from that value. Operating income is not defined under GAAP by FASB. This permits individual companies to interpret what is and what is not ‘unusual’. The result is a varied interpretation of items and charges, where same specific type of charge may be included in Operating earnings for one company and omitted from another. S&P reviews all earnings to insure compatibility.

Adjusted operating earnings may exclude non-recurring expenses such as restructuring charges, asset sales gains, major litigation charges, goodwill write-downs and other write-offs.

Having an independent body to ensure compatibility and continuity adds credibility to the “operating” earnings time series. S&P effectively prunes out, when it deems appropriate and consistent, non-recurring expenses such as restructuring charges, asset sales gains or losses, major litigation charges, goodwill right downs and other write-offs that are unlikely to recur in the future and are thus regarded as one-off items that distract from the recurring earnings stream and true operating results. S&P does not only adjust earnings upwards. For example, Q3 2012 “operating” earnings were reduced below “as reported” for 50 of the S&P 500 companies.

While it is advisable to take account of “recurring non-recurrings” when analyzing individual companies in order to assess management, the notion becomes preposterous when used for an index such as the S&P 500.

The chart below shows how trailing 12-month “operating” earnings diverged from “as reported” since divergence began in 1982.


Between 1982 and 2000, the average spread was 7.4% with a 7.2% median within a stable 0-17% range. Since 2001 however, the average has shot up to 20.4% with an 11.8% median. The internet bubble and, particularly, the financial crisis have both resulted in huge “unusual” charges, substantially larger than what we had seen in the previous two decades. At its current 11.5%, the spread is back within its past normal range.

In both these truly exceptional periods, many companies, large and small, reported losses, some significant, others simply humongous. To appreciate the uniqueness of the 2008 debacle, consider that for Q4 2008, 140 S&P 500 companies, nearly 1 in 3, reportedlosses, 97 of which also recorded “operating” losses per S&P.

As a result of the carnage, trailing 12-month earnings for the S&P 500 Index collapsed to a trough of $6.86 in March 2009, down 92%from their June 2007 peak of $84.02. The last time trailing earnings were below $7.00 was in April 1973, 35 years before! “Operating” earnings, meanwhile, troughed in Q3 2009, declining 57% from their $91.47 peak of June 2007 to $39.61.

Many investors, strategists and economists have missed the March 2009 market trough because they blindly used the “as reported” data. Had they done a little more thinking and research they would have realized that:

  • While reported earnings had cratered 92%, the value of corporate America could not have shrunk anywhere near that.
  • Importantly, a very large part of the losses were in financial companies due to the  collapsing housing market and the Lehman failure. Many recorded humongous losses while their stock price sank as bankruptcy loomed. This extraordinarily unique combination of sky-high losses and stock prices diving towards zero created a very unique situation for stock indices: companies with then almost negligible market weights were recording humongous losses.

Here’s what Wharton professor Jeremy Siegel wrote in a Feb. 25, 2009 WSJ article:

(…) As the fourth-quarter earnings season draws to a close, there are an estimated 80 companies in the S&P 500 with 2008 losses totaling about $240 billion. Under S&P’s methodology, these firms are subtracting more than $27 per share from index earnings although they represent only 6.4% of weight in the index. (…)

I added these details in my March 3, 2009 post S&P 500 P/E Ratio at Troughs: A Detailed Analysis of the Past 80 Years:

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.

Incidentally, the S&P Financial sub-index recorded “operating” losses in each and every quarter of 2008 for a yearly total of $21.24 ($37.96 “as reported”)

  • Another important and overlooked consideration is that many of the companies that recorded huge losses in 2008-09 either went bankrupt or were substantially restructured or acquired. A conceptually valid valuation method like the Shiller PE, measuring 10-year average earnings against a current index, is thus including in its denominator, during 10 years, the huge losses recorded by companies that are no longer included in its numerator, these companies having in fact been replaced by other, profitable, companies.

Humongous or very large losses were recorded in 2008 by companies such as AIG, GM, Merrill Lynch, Marshall & Ilsley, MBIA, Wachovia, all companies then part of the S&P 500 Index but no longer. As to the bubble, everybody remembers the infamous Enron and Worldcom, just to name a couple. Their losses still impact the 10 year average earnings even though they have no contribution to the actual index value.

The losers are long gone but their losses remain!

This is like assessing a baseball team’s current batting line-up using 10-year data that includes the dismal stats of now deceased players. How useful is that?

Cliff Asness, a Ph.D. turned hedge fund manager (AQR Capital) recently wrote a long note “An Old Friend: The Shiller P/E” which was extensively disseminated by the media and, particularly, the bear population . The notorious quant statistically looked at most arguments against the Shiller P/E and categorically ended the debate:

Those who say the Shiller P/E is currently “broken” have been knocked out.

Unfortunately, Asness did not stumble of the truth this time since nowhere does he mention that his current roster has little to do with that which generated the 10 year record.

While the internet is filled with Shiller supporters, I failed to find a good analysis of the actual track record of this valuation method. It may be because the record leaves a lot to be desired.

The long term average of the Shiller PE is 16.5 and the median value is 15.8 which most people seem to use as the dividing line between cheap and expensive. I will let you judge by yourself based on your own personal needs and risk aversion, only to point out the following (click on charts to enlarge):

  • Post WWII investors using the Shiller P/E would have had very few buying windows, to say the least.
  • The 20-year period between 1955 and 1975 was a very long one to stay on the sidelines.
  • One could have bought the 1974 low, only to be back on the fence in early 1976, buying again during the next 10 years but sell out in 1986, only to watch equities appreciate 2.5 times to 1996 (I am excluding the internet bubble years).


Cliff Asness computed 10-year forward average returns from different starting Shiller P/Es since 1926:image

(…) while not near its prior peaks, today’s Shiller P/E is high versus history. In fact, it’s higher than it has been 80% of the time since 1926.

The media and the bears loved that last sentence and the supporting table! Asness continued:

(…) Ten-year forward average returns fall nearly monotonically as starting Shiller P/E’s increase. Also, as starting Shiller P/E’s go up, worst cases get worse and best cases get weaker (best cases remain OK from any decile, so there is generally hope even if it should not triumph over experience!).

In particular, in the ninth bucket (where we are today at 22.2) the average real stock market return over the next decade does not break 1%. The worst case is a horrendous -4.4% real return per annum (those who think the disappointing post-2000 decade-long results can only happen from super high P/E’s are mistaken), and the best case is very good, though less wonderful than the much better best cases from lower starting Shiller P/E’s.

Asness then goes on listing some caveats but never mentions that readings below 15.8 occurred mainly before 1950. He does, however, confess that

(…) I would, if trading on a tactical outlook, give the Shiller P/E some small weight, particularly when it’s above 30 or below 10.

There you go! Cliff Asness shared the Truth with us. Since 1927, that is over some 1,030 months, the Shiller P/E registered below 10 thirty-seven times (3.6%), all but two months being pre-1942, and was over 30 eighty-nine times (8.6%), all but 2 being between 1996 and 2007.

The Shiller P/E may be an “old friend” to Cliff Asness (although he was born in 1966), let’s hope it is not his best friend.

“What alternatives do people have?” This authoritative question is from Professor Shiller himself.

Here’s an alternative: my personal old friend the Rule of 20 which says that fair P/E is 20 minus inflation. When the actual P/E on trailing EPS plus inflation is below 20, equities are undervalued. Above 20, risk increases as overvaluation rises.


Admittedly not perfect but, in my book, substantially more sound and useful than the Shiller P/E. I must admit that I was actually hoping to find another friend in the Shiller P/E that would complement the Rule of 20. Alas, this is not my kind of friend.

The Rule of 20 is a risk management tool, enabling investors to measure the downside against the upside in order to decide whether the risk/reward profile fits their own personal needs.

Most strategists tend to analyze the economy and the market fundamentals before assessing if the market P/E fits their scenario. I prefer the opposite approach. First, I objectively measure the risk/reward ratio, paying particular attention to trends in the 2 components of the Rule of 20: earnings and inflation.

When equities are expensive, I work on my golf game or go salmon fishing. When  equities are cheap, I then assess the economy and the fundamental trends to see if a trigger is near that might unlock values. Here’s the Rule of 20 barometer since 1980.


I have been blogging since January 2009, providing my readers with balanced, objective and detailed views, caring more about preserving than increasing capital (the return of capital concept vs return on capital). I have generally been positive on U.S. equities since March 2009 with three interim periods where I advised caution. The Rule of 20 has been very useful helping me objectively measure risk vs reward during these very volatile years. However, a disciplined following and objective analysis of the economic and financial environment is always needed to supplement the mathematical risk/reward equation (detailed track record).


U.S. equities are very cheap currently. While Q3 earnings were down somewhat (-4.2% Q/Q, -3.6% Y/Y), they are not in free fall like in 2007 when they dropped 13.2% in Q3 2007 from their Q2 peak level. Also, inflation remains contained in the 2% range and oil prices, a big driver of inflation, are behaving reasonably well currently. Inflation was rising rapidly in the U.S. between August 2007 and July 2008 which, combined with declining earnings, caused a sharp 18% decline in the Rule of 20 fair value (yellow line in the Barometer chart above) between August and November 2007.

The U.S. economy has been showing encouraging signs lately. The Fed is printing money like there is no tomorrow (literally) and is actively keeping interest rates to the floor, the ECB is taking care of the Eurozone fat tail risk and China seems to have stabilized its economy and could be about to re-stimulate more aggressively. Normally, such an environment is quite enough to unlock a cheap equity market and justify a green light on equities.

Yet, I am keeping a yellow light for now, essentially because of the looming fiscal cliff which, with odds no better than 50-50, would cause a U.S. recession as early as Q1 2013. This would most likely axe 2013 earnings by 10-20%, eliminating most if not all of the current 25% undervaluation. Betting one’s own money on politicians is generally not without peril. The current undervaluation is so large that I would rather wait to see if politicians deliver or not. This has been a wise approach in Europe.



The Rule of 20 (fair PE = 20 minus inflation) is getting more popular as more and more investors get to know it and appreciate its simplicity and usefulness.

One concern some investors have is the use of the CPI as a proxy for inflation. Some say that inflation calculation methods have changed over the years; others claim that the CPI is manipulated and does not accurately represent true inflation. However, to the extent financial markets use the official CPI for their assessment of inflation, it remains the best benchmark as it represents the views of the vast majority of investors.

The impact that all the QEs are having on interest rates is more troubling. The CPI in the Rule of 20 is but a convenient proxy for a “real discount rate” to apply to equity valuation. As the Fed keeps managing interest rates down, below their free market level, should it have an impact on the discount rate investors use in their valuation?

David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors, argues that equity valuation is positively impacted by the QE-induced low interest rates:

(…) Assume that the long-term interest rate, defined by the ten-year Treasury note, is going to be in the vicinity of two percent for the next five to ten years. What would you then use as an equity-risk premium so you could calculate the value of the US stock market? Let’s run some numbers to try to predict where the market is headed.

A traditional equity-risk premium calculation would be 300 basis points over the riskless rate. (…) If you use the ten-year yield and a two percent estimate, you will derive an equity-risk premium comparative interest rate of about five percent. That is two percent on the riskless piece plus three percent on the equity risk premium, for a total of five. This calculation leads you to the basic conclusion that the stock market is priced properly and at an equilibrium level at twenty times earnings. Twenty times earnings is not excessive under this set of assumptions. The market would be neither cheap nor richly priced.

Apply the twenty multiple to the earnings estimates that we have for 2013. (…) For the purpose of this counting exercise, I am going to use $90. Ninety times a PE of 20, which we derive from an equity-risk premium of 300 basis points over the ten-year Treasury yield, gives us an $1800 price target on the S&P 500 Index. (…)

Will the Fed stay in its present mode for that long? No one knows. Given the current concentration of intensity, effort, and communication on the employment situation in the US, you can easily guess that it will take four to seven years to achieve an unemployment rate low enough to warrant the Fed changing its policy stance. One Fed president has now called for continuation of this policy until the unemployment rate is 5.5 percent. Another Fed president has repeatedly called for this policy to continue until the unemployment rate falls below seven percent. (…)

Kotok is adding a 300 points “traditional” risk premium to interest rates. The inverse of that discount rate gives him a P/E of 20 (1/(2% + 3%)). Kotok is precisely playing Ben Bernanke’s tune. The Fed wants to keep rates low enough for long enough to push people into riskier assets, potentially creating a wealth effect that, if translated into more spending, would help pull the economy out of its morass.

As a direct result of the Fed’s actions, real interest rates are currently negative, a truly unusual situation.


Negative long term rates have happened sporadically before, but only during periods when inflation spiked. Currently, U.S. inflation is below 2%.


This is clearly an exceptional situation. Should we normalize interest rates or used them as currently manipulated? Kotok is willing to bank on current low rates on the justification that artificially low rates are to continue as far as the investing eye can see.

Kotok thus derives a 5% earnings yield (20x P/E) assuming 2% long term interest rates and a 300 points “traditional equity-risk premium”. However, the foundation for that “traditional premium” is not readily visible from the chart below:


There is more of a “tradition” in the ratio of EY to interest rates: the range of 0.7 and 1.4 times 10y Treasury yields is more stable if one excludes the two very fat tails in the chart below. On that basis, EY should now be ranging between 1.4% and 2.8%, justifying P/E multiples between 35 and 71.


Obviously, the market has not (yet?) embraced Kotok’s approach. Investors are in effect normalizing interest rates.

Inflation is not as easily manipulated. Its use in the Rule of 20 provides rationality in most exceptional circumstances. The chart below (click chart to enlarge) clearly shows how the Rule of 20 values have historically remained within the 15-25 range except in periods of exceptional greed and fear. The red markers on the blue line indicate actual market highs and lows.


Equity markets constantly oscillate between greed and fear. In fact, precious little time is actually spent at the median valuation level. There is mean reversion but also mean aversion!

The Rule of 20 captures these fluctuations using two basic statistics: the inflation rate and the P/E on trailing earnings. As the chart shows, there have been a few periods when valuations remained excessive for many years:

  • The “nifty fifties” resulted in overvalued equity markets between 1968 and 1973.
  • A very difficult recession, exceptionally high inflation and interest rates and uncertainties on the eventual success of the Volcker and Reagan medicines kept markets deeply undervalued between 1982 and 1986.
  • Wild speculation during the internet revolution brought valuations way above normal between 1998 and 2001.

Such exceptional periods of over and under-valuation have always brought claims of “new paradigms” and “this time, it’s different”, severely testing investors discipline.

With the exception of a brief period late in 2009 and early in 2010, the S&P 500 Index has been in undervalued territory for nearly 4 years, even though the Index has more than doubled during the period! Why is that?

  • Earnings have also more than doubled;
  • Inflation has remained subdued.

The Rule of 20 currently states that fair P/E is 18.3x trailing EPS of $98.69. That’s 1800 on the S&P 500 meaning 23% upside. David Kotok is thus partly right, but for the wrong reasons.

Should we take the plunge?

The macro risks are pretty well laid out in front of everybody to see:

  • Earnings seem to be peaking.
  • Revenue growth is near zero.
  • Profit margins are very high and flattening.
  • The U.S. economy is running on but one cylinder.
  • Europe is in as complex a mess as possible.
  • China is landing not so softly.
  • The U.S. fiscal cliff is straight ahead.
  • Nobody really credible is in charge just about anywhere one looks.

That said, I still remember 1982’s gloom and doom. Treasuries were yielding 13% then! The S&P 500 closed at 107 in July 1982, exactly its June 1972 level. Alas, nobody has a monopoly on lost decades.

That said, July 1982 marked the beginning of a powerful bull market that peaked at 330 in August 1987. If you had closed your eyes, pinched your nose and bought on the Rule of 20 reading until it crossed into overvaluation territory in the spring of 1987, you would have tripled your money taking virtually no valuation risk.

Is this time different?

The biggest risk is obviously tied to earnings. Since 1938, there have 13 periods of meaningful earnings decline. Equity markets nonetheless rose during 7 of these periods (see Banking (Betting) on Bankers?).

However, in all 7 cases, inflation declined along with EPS, further proof of the validity and importance of the Rule of 20. In effect, a 1.0% decline in the inflation rate can offset a 5% drop in trailing earnings. Just as important, however, was that investors expectations were lifted by declining interest rates and receding commodity inflation. We can’t expect interest rates to decline much from here, can we? Will the world economic slowdown offset the effect of QEs of all types and nationality on commodity prices?

I debated in September on the prospects for inflation in What If The Fed Has It All Wrong?, erring negatively, arguing that all the QEs in the world are merely pushing on strings while artificially boosting commodity prices and driving inflation upward as a result. Most central banks have squarely abandoned inflation targets, focused as they are on boosting growth.

Can we have our cake and eat it, too?

Perhaps, if oil prices decline.

Saudi Arabia has recently said that it wants lower oil prices. According to Bloomberg, the Saudis recently

chartered at least seven very large crude carriers to load a total of about 14 million barrels in October, compared with about four a month so far this year, according to data from Athens-based Optima Shipbrokers Ltd. Brokers report tanker bookings when the deals are provisional and charters are then sometimes canceled. (…)

A one-way journey to the U.S. Gulf from Saudi Arabia takes about 40  days to complete, according to Optima. That implies the cargoes will probably be discharged in the second or third week of December.

President Obama may decide this is too late for Christmas (and the elections?) and release some of the U.S. strategic petroleum reserves in sync with Europe.

A meaningful decline in oil prices would do wonders for world economies and equity markets:

  • world consumers would get an instant and much needed break;
  • businesses would also immediately benefit;
  • consumer inflation would decline;
  • lower producers costs would likely trickle down to consumer prices, lifting expectations of slow inflation for an extended period.


  • Israel-Iran: no end in sight.
  • Iran is helping Syria’s government;
  • Saudi Arabia is helping Syrian rebels;
  • Saudi Arabia’s budget needs €100 to balance.
  • Venezuelan production? Mexican production? Nigerian production? Etc…

This time is different!

  • This time, whole countries are bankrupt and in depression;
  • Big countries such as Italy and France are seriously teetering;
  • Austerity measures keep being piled on;
  • Eurozone politicians have lost control leaving Eurocrats in charge;
  • Technocrats are meeting endlessly seeking common grounds to 17 widely different agendas;
  • Many major banks are on artificial life support;

Briefly stated, Europe is a catastrophe in slow motion that nobody can confidently predict how nor when it will end;

  • The U.S. looks only a little better;
  • Not so for U.S. politicians;
  • China: landing? Hardly or softly?
  • Can China recover without pulling commodity prices, including oil, higher? 
  • Central banks are down to experimenting, having pushed aside their own rules and regulations as well as anything resembling monetary discipline;
  • Monetary stimulus is no substitute for fiscal stimulus. However, few countries, least of all Europe and the U.S.A. are in a position to provide the necessary fiscal medicine.

In all, the world is a mess with little visibility for a turnaround mainly because normal market forces are ineffectual, being relentlessly overruled by political and/or technocratic interventions.

Yet, inflation is not slowing. Eurozone inflation was 2.7% in September, up from 2.4% between May and July. U.S. inflation was 1.7% in August, unchanged from May-June but up from July’s 1.4%. Core CPI has slowed a little but median CPI has held steady at 2.3% since May and the last 2 months annualized rate was +2.4%. The US Daily Index at the Billion Prices Project @ MIT has been accelerating lately, rising at a 3.8% annualized rate since June.


The hope is that central bankers’ bets succeed and growth reappears without higher inflation. If the monetary experiments fail and growth remains slow or gets even slower, profits will decline. If inflation takes off at a rate faster than economic growth, valuation will suffer. Neither “ifs” are good for equities.

Prudently waiting for positive evidence on profits and inflation is a wise attitude. What opportunity cost there might be is offset by the risk avoided. The valuation gap is wide enough to leave ample upside if and when the skies begin to clear. Meanwhile, quality, good yielding stocks remain the safer bets.


What If The Fed Has It All Wrong?

I wrote an exclusive article for Seeking Alpha in which I expand on the following points:

  • Quantitative Easing-induced wealth effects may be wishful thinking;
  • Earnings are the primary drivers for equities and they have peaked;
  • QE3 could be highly counterproductive if commodity prices rise as a result like in previous QEs;
  • Another problem with Bernanke’s wealth effect thesis lies with the new reality in America. Lately, income and assets have been so significantly redistributed that only a tiny few actually feel a wealth effect from rising equity prices;
  • The “wealthy few” may nevertheless have much less after-tax income when politicians finally address the looming fiscal cliff. It is these wealthy people who run American corporations, keeping them lean and mean and flush with cash.
  • The less affluent — the other 250 million people — are little concerned by an eventual wealth effect but highly, directly and immediately impacted by the side effects of all these QEs, namely rising commodity prices and near zero interest rates.
  • At previous QE program launches, equity markets were similarly undervalued, but economic trends were then more positive.
  • If the Fed has it all wrong and the only effect of QE3 is to boost inflation, only God knows what will happen.
  • Bankers are merely experimenting with totally unproven ways hoping to gain enough time until more responsible politicians emerge. Given the significant risk still facing us until Godot arrives, investors should await more evidence that either earnings resume their uptrend or some kind of miracle(s) happen.

Star  The complete article with charts is right here. Star