If you have played the market rally since last March, you have involved yourself in what perennial bears called the biggest sucker rally in history. Well, happy suckers, you should now start ducking!

After a 65% jump in the S&P; 500 Index, while trailing operating eps declined another 13%, all PE charts on 12-month trailing earnings are screaming “Sell !!”

  • The conventional PE ratio is 27.7x operating eps, up from 15.6x at the end of February 2009;
  • The PE10 cyclical ratio, beloved by bears last spring, is now 18x, up from 12x last February.
  • Doug Short’s chart of the inflation-adjusted PE10 ratio is now 20x, up from 13.4x


More importantly, the Rule of 20 PE (see S&P 500 Index PEs at Through: A Detailed 80 Year Analysis) which gave a strong buy signal at 16x last March, is currently high at nearly 28x when a fair PE should be 18-20x given current inflation rates.


However, the severity and suddenness of the economic downturn at the end of 2008 was such that S&P; 500 operating earnings went negative in Q4-2008, evaporating from almost $16.00 in Q3. But corporations quickly adjusted their costs and operating profits recovered to the $10 level in Q1-2009, $14 in Q2 and $16 in Q3.

It would therefore be simply wrong to disregard the fact that 12-month trailing eps are meaningfully reduced by the Q4-08 $0.09 loss, especially since corporate America has successfully reacted to the dire economic conditions.

There are 3 ways to normalize eps without making a 2010 earnings forecast:

  1. normalize Q4-08 eps from the $0.09 loss to, say, $5.00 (the mid-point between Q4-08 and Q1-09). Current trailing eps would thus be about $45.
  2. Annualize the last 9 months. Trailing eps would be $53.
  3. Annualize Q3-09: eps would be $63.

“Trailing” PEs thus decline to 24x, 21.8x and 17.5x respectively which, using the conventional PE approach, says that equities are overvalued by 17-60%.

Under the Rule of 20 (fair PE = 20 minus inflation), using 2.0% inflation as per the core CPI (last 6 months annualized), the S&P; 500 Index is at best 2-3% below fair value (17.5 + 2.0 = 19.5). At worst, it is 30% overvalued (24 + 2.0 = 26).

This is the first time since March 2009 that the Rule of 20 gives such downside against so little upside. In August, when the S&P; 500 was 1026 I wrote:

If current estimates prove accurate, equity markets have room to advance 17-25% to 1120-1280, before they reflect fair value on these numbers.

In August, estimates were for annualized eps of $60 and $64 for Q3 and Q4 2009. Q3 came in at $63 while current Q4 estimates are $67.

Based on Q4-2009 estimates, the Rule of 20 PE is 18.4 (16.4 + 2.0), 8% below fair value (S&P; 500 = 1200.) While still reasonably attractive, the margin of safety has narrowed significantly.

Given the fragility of the economy, of the banking system (housing and CRE remain dangerous), of the US dollar and the US budget deficit, equity markets that are merely fairly valued are not particularly attractive.

It is important to note here that core CPI has accelerated from 1.5% (4 months annualized) last August to the current 2.1%, shaving 3% off fair value. Trends in core inflation need to be monitored closely here.


Under the current very difficult economic conditions, corporate America has been able, thanks to unprecedented layoffs, extremely low interest rates, a weak dollar and big declines in non-wage expenses, to restore its quarterly earnings to levels that are only 25% below their 2006-2007 average level.(Nominal GDP chart from Econompicdata)

Current S&P; 500 Index consensus estimates for 2010 are $75 (according to S&P;) with quarterly levels rising from $66 annualized in Q1 to $82.30 in Q4-2010. This would be a very steep 24% rise in but 4 quarters. If so, eps one year hence would be only 3% lower than the 2006-07 average quarterly level. My sense is that it is premature to display such optimism.

image This RBC Capital Markets’ eps revision index chart supports the notion that excess optimism is creeping in.

Macro earnings models are no doubt positively influenced by the unprecedented jump in productivity during this cycle. US corporations have been extremely swift in reducing labor costs during the down cycle. Labor costs fell at a 5.2% annual rate in Q3 after dropping 6.1% in Q2, capping the biggest 12-month drop since records began in 1948.

But many obstacles remain as costs can only be shaved up to a point:

  • Top line growth remains very weak. As David Rosenberg writes:

image Gross value added in the non-financial corporate business sector, which is a proxy for nominal sales, fell 0.4% in Q3 and is negative now for four quarters in a row. The YoY trend in this GDP sales proxy is now -5.6%, compared with -4.3% in Q2, -3.3% in Q1, and -1.4% in Q4 of last year.

  • Labor costs will no doubt rise as the economy keeps recovering.
    alt=”image” align=”right” src=”″ /> In fact, we can argue that labor costs MUST rise if we are to have a recovery since labor costs are also labor income, the main feed to personal income, itself the main feed to personal expenditures.
  • Corporate profit margins will have difficulty avoiding compression as labor costs rise (through higher wages, hours worked and/or employment). Core PPI has been slowing down rapidly throughout 2009 indicating increasing difficulty for corporations to raise prices in both the goods and services markets.



  • Non-wage expenses fell at a 6.7% annual rate in Q3 owing to a lower tax bill, lower depreciation expense and lower interest costs. Difficult to expect a repeat of these in a rising economy.

Finally, are earnings really as good as perceived when only looking at S&P; 500 companies? David Rosenberg analyzed recent corporate profits from the national accounts. Profits surged $123 billion in Q3 from Q2.

Interestingly, $97 billion of that $123 billion profit increase came out of the financial sector — so one area (with a 25% share) accounted for about 80% of the pickup. Very skewed performance. (…) Profits from non-financials barely rose at all in Q3 — up 0.6%, which was actually the second worst showing in the past six quarters (from +2% in Q2 and +2.9% in Q1 — not annualized). At an annual rate, that is a 2.3% gain — not much to write home about, and still down 6% from last year’s recession levels.

Much is being made of the profits that are now being derived from the stronger global (mainly the BRIC countries) economies (though for the total profit pie — not just the S&P; 500 — the overseas operations only make up 20%). Indeed, earnings derived from global operations did rebound 6.7% (29% annualized) after three down quarters in a row, and still down 19% on a YoY basis.

In total, profits are up 20% from their worst levels. Outside of the snapback in the financials, which received tremendous life support from the government, profits are up less than 7% from the lows.

We know that banks have strongly benefitted from huge interest rate spreads owing to the very favorable yield curve while “delaying” booking losses from their deteriorating housing and CRE loan books.

For all these reasons, I would be particularly cautious in using 2010 estimates at this point as there definitely seems to be a fair bit of optimism.

In conclusion, US equities are fairly valued using annualized Q3-2009 eps and 2% inflation. They could rise another 8% to 1200 (S&P; 500) if Q4-2009 reach the expected $67 level but the risk/reward ratio has become unfavorable for the first time since March. The risk is accentuated by the fact that estimates for 2010 appear to display excess optimism given current economic conditions.



Here is my latest equity valuation analysis. It makes me feel like an economist (“on the one hand, on the other hand…”) but that’s the way it is!

Previous analysis are archived under the Equities Valuation tab.



On March 7, 2009, I published an analysis S&P; 500 VALUATION ANALYSIS: NEAR BOTTOM in which I demonstrated that the “Rule of 20” is the most appropriate tool to value equity markets. I argued that this approach, which says that the sum of the S&P; 500 Index PE multiple and the inflation rate should fluctuate around 20, was in fact more appropriate than focusing on absolute PE ratios which take no account of inflation rates.

On March 16, I published S&P; 500 INDEX PE AT TROUGHS: A DETAILED 80 YEARS ANALYSIS to further document the case. I concluded that:

  • Using historical absolute PE lows to assess the potential downside to the S&P; 500 Index is simplistic and based on superficial, non-rigorous analysis. The absolute historical lows used by the bears, while strictly accurate, were attained in high inflation periods, not comparable to the present.
  • Using the Rule of 20 to assess PE multiples takes into account the inflation environment and is thus a better tool to value equities in general.
  • Using this method, and assuming inflation rates in the 0-2% range, trough PE multiples should be 12-14 times trailing earnings.
  • The current financial crisis is substantially distorting S&P; 500 earnings, both reported and operating, in an unprecedented way. Using trailing earnings, reported and operating, can result in a meaningful underestimation of Index earnings in the present environment.
  • Macro earnings estimates are more appropriate in the current exceptional circumstances. Goldman Sachs’ $63 estimate for 2009 appears conservative in light of historical evidence. A low probability worst case scenario would take earnings down to the $43 level.
  • Trough valuation analysis shows trough S&P; 500 Index levels at 720 using 2009 estimates (which are lower than trailing), with a low probability downside risk to between 516 and 602.
  • image

    The S&P; 500 Index troughed on March 9 at 666 and is up 37% since. Meanwhile, trailing operating earnings have continued to decline. They are currently around $43 and all indications are that they could trough around $41 by the end of the summer.

    The combination of declining earnings in a surging market has brought the “Rule of 20” multiple from 16 to 21.1, slightly above its historical median of 20 (range of 15 to 25). As a result, the risk/reward ratio has moved from extremely positive (16/20) to somewhat negative (21/20).

    Using earnings estimates as opposed to trailing earnings, one could justify buying equities at current levels, given that estimates for 2009 are about $60. On that basis, the S&P; 500 Index trades at a “Rule of 20” multiple of 15 (as is the absolute PE since the current inflation rate is about zero). Investors who have faith in such estimates and who expect inflation to remain near zero could keep buying stocks.

    The case in favor of using estimates at present is supported by the fact that current trailing earnings include the exceptional Q4 2008 S&P; 500 Index EPS of $-0.09. So far in Q1 2009, earnings are already running at a $51 annualized rate.

    Personally, I prefer using the comfort of trailing earnings, especially in an  environment where major economic and credit issues remain largely unresolved and very challenging looking forward given the general need to deleverage. We must also not dismiss the risk of deflation which would negatively impact both earnings and PE multiples.

    Let’s keep in mind that Mr. Market has merely reacted to “less bad” economic news. Green shoots may never become flowers. For now, investors increasingly expect blossoming from the number of green shoots spotted here and there. Yet, house prices keep declining, credit markets remain tight and consumer spending is weak. To be sure, an inventory cycle is about to erupt. But as long as final demand does not recover decisively, the bears may still have a shot at their sucker rally…even though the suckers are now 35% richer.



    Equity prices = Earnings per Share x Price/Earnings ratio. A 2-parts analysis trying, firstly, to estimate S&P; 500 earnings for 2009 and 2010 and, secondly, what is an appropriate valuation level for US equities currently and looking forward.



    2009: $40-45 on S&P; 500 Index

    2010: $60-65

    Goldman Sachs wisely splits the S&P; 500 eps between Financials and Non-Financials, estimating eps of $63 and $71 for 2009 and 2010 respectively under the following reasonable economic assumptions.



    The estimates for Financials assume total credit cycle-related losses of $2.1 trillion. Here is the contribution by sectors:


    Net profit margins decline to their LT average. This excludes Financials and Utilities which helps explain that margins do not decline below 5.8%. Given the severity and reach of the recession, this is a questionable forecast.


    RBC Capital Markets provide the range of possibilities under different margins assumptions.


    So, the worst case scenario is $40, the best case $60 for 2009. Given that margins normally bottom after the end of the recession, a target of 5% margins for 2009 ($40-45) appears more reasonable while a 6% margin for 2010 ($60-65) is possible.

    Goldman writes:

    At some point during 2009 investors will begin to disregard losses from Financials’
    provisions and write-downs. We expect the stock market to trade on a pre-provision and
    write-down EPS basis when we have greater clarity on Financials-related fiscal policy and
    as Financials losses begin to decelerate. The reduction in the pace of Financials’ losses will
    be a clear positive for the trajectory of the broader market.

    How the current profit cycle compares with history


    Ex-Financials profit cycle: Profits outside the Financials sector peaked in
    September of 2008, almost one year into the current economic recession, and fell
    by 9% (LTM basis) in the fourth quarter. Historically, ex-Financials profits decreased
    by 16% during the average profit contraction, although the past two cycles have
    posted more severe declines. We estimate that ex-Financials earnings will decline by
    33% in 2009 from their peak, in-line with the worst case we have seen in the past 40
    years. Our forecast is an annualized estimate, suggesting the peak-to-trough decline
    could be more severe when measured on a quarterly basis.

    Financials profit cycle: Financials earnings declined by 166% between June 2007
    and December 2008, marking the worst profit contraction for Financials during
    the past 40 years. The only comparable historical period is 1987, when Financials
    profits declined 109%. That profit contraction lasted nine months, and Financials
    returned to record profits six months later. In the current cycle, Financials profits have
    been declining for 18 months and we believe the sector will continue to lose money.
    We estimate that Financials will lose less money in 2009 compared with 2008, so the
    166% profit contraction will mark the peak-to-trough decline for this cycle, in our




    When will earnings turn up? Watch the leading indicators. Here is RBC Capital Markets approach:

    We continue to focus on the leading indicators to determine when the economy has passed its point of
    maximum cyclical weakness. Our favorite comprehensive gauges include the ISM Manufacturing Index
    and the Conference Board’s Composite Leading Economic Indicator. Both measures have generated
    reliable signals at business cycle turning points for the past 48 (for the Conference Board) to 60 (in the
    case of the ISM) years. An upturn in the indicators usually occurs 6-9 months ahead of an improvement
    in GDP growth, 9 months ahead of corporate earnings growth and is coincident to 1-2 months behind
    turns in the stock market. Equities are likely to remain at risk absent an eventual
    upturn in the economy and earnings and this is why investors need to keep close watch on the leading


    The recent small upticks in the Conference Board’s LEI in December and January provide some hope: