U.S. Equities: 9% Upside to Fair Value, Caution Remains

by: Denis Ouellet, CFA

With 91% of S&P 500 companies having reported, Q1 earnings season is essentially over. The facts are:

  • Q1 operating EPS totaled $22.58, +16.5% YoY and +3.0% QoQ.
  • Only 4 of the S&P 10 major sectors grew EPS more than the average: Energy (+29%), Industrials (+23%), IT (+30%) and Materials (+56). Both IT and Industrials Q1 EPS were down vs. Q4 2010 EPS.
  • Q1 sales rose 13% YoY on average but only Energy (+25%) and Financials (+26%) beat the average.
  • Sales rose 3% sequentially but 4 sectors showed declining sales QoQ: Consumer Discretionary (-8%), Consumer Staples (-7%), Industrials (-13%) and IT (-9%).
  • Q1 beat rate was 63% on EPS and 72% on Sales.
  • Trailing 4Q EPS now stand at $86.97, up 3.8% from 3 months ago.
  • Full year 2011 estimate is $98.19, +17.2% YoY and up nearly $1 from the April 27 estimate of $97.21.
  • Analysts are forecasting earnings to accelerate in Q4. The YoY gain is estimated at 15.7% in Q2, 16.5% in Q3 and 20% in Q4.

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Overall, this was a reasonably good earnings season. Upon deeper analysis, however, the sectorial breadth is poor on both sales and EPS. Given the generally more subdued recent economic data and rising costs pressures, these next three quarter estimates look optimistic.

The "Rule of 20" takes into account changes in inflation rates to help set fair PE under different inflation environments. U.S. inflation data have strongly accelerated lately: total CPI was +3.2% YoY in April but +6.2% annualized in the last 3 months. Core CPI is up 1.3% YoY but 2.1% annualized in the last 3 months. The Cleveland Fed Median CPI is up 1.4% YoY and its 16% trimmed-mean CPI is +1.7% YoY and +3.2% annualized during the last three months.

However, the Rule of 20 traditionally uses total CPI. With current inflation at 3.2%, fair PE of 16.8 targets 1461 on the S&P 500, 9% above current levels. The chart below clearly shows the impact of rising inflation on fair value as the inflation rate is rising faster than EPS.

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The call on inflation is critical at this point and while the odds are in Bernanke's favor (Bernanke's Inflation Bet Looks Good), the call is not a slam dunk.

Equity markets are likely to remain volatile in coming months as uncertainties about inflation, interest rates and commodity prices, all interlinked, will dominate and fluctuate.

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Recent declines in U.S. long-term interest rates indicate that investors currently believe that Bernanke's bet looks better than Bill Gross' (Ready for D-Day?).

The caveats of my March 29 post (U.S. Equities: April Peak?) remain:

While the Rule of 20 provides a rigorous mathematical and time-tested approach to PE multiples on U.S. equities, it does not account for external risks. While many external factors are at play at any given time, it is fair to say that the current environment has more than its fair share of known unknowns (see Known and Unknown (Groundhogs)), many of which are potential game changers:

Liquidity is currently flowing liberally in the U.S. economy and into its stock market. Yet, many of the above noted groundhogs could quickly change the outlook significantly. In addition, the era of excess liquidity could well end abruptly on June 30 or, more likely, fade away gradually during the summer months. Finally, economic surprises have been negative so far in Q2.

Citigroup Economic Surprise Indices

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It is therefore likely that high uncertainty will keep PE ratios below what they would otherwise be in a more "normal" environment.

This is why caution is warranted here given the limited 9% equity undervaluation. It will be psychologically very difficult for investors to bid stocks up when PEs are no longer terribly attractive and given the number and dangerousness of the groundhogs out there.

For the complete analysis, go here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.