Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

UPGRADING EQUITIES TO 3 STARS

With 76% of the companies in the S&P 500 reporting actual results for Q4 to date, more companies are reporting actual EPS above estimates (69%) compared to the 5-year average, while fewer companies are reporting sales above estimates (49%) relative to the 5-year average. The percentage of companies reporting EPS above the mean EPS estimate is equal to the 1- year (69%) average, but above the 5-year (67%) average.

In aggregate, companies are reporting earnings that 3.6% above the estimates. This surprise percentage is below both the 1-year (+4.9%) average and the 5-year (+4.7%) average.

The blended (combines actual results for companies that have reported and estimated results for companies yet to report) earnings decline for Q4 2015 is now -3.7% (-3.9% on Dec. 31, 2015). If the Energy sector is excluded, the blended earnings decline for the S&P 500 would improve to 2.4% from -3.7%.

The blended revenue decline for Q4 2015 is now -3.5%. If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would jump to 0.6% from
-3.5%. (Factset)

Seven of the 10 sectors are reporting better than expected EPS. Materials, Energy and, more surprisingly, Financials are below expectations.

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Thomson Reuters’ data show similar sectorial trends for Q4’15. Note that EPS have worsened mainly for Energy and Financials:

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Total S&P 500 companies EPS are expected to come in at $117.28 at TR, unchanged in recent weeks.

The problem is that expectations for Q1’16 have materially darkened. TR’s tally show –4.8% YoY in Q1, well below the +2.3% that was expected on Dec. 31. Energy earnings are again the bad guys but Industrials, Materials and IT are also getting significantly worse while Financials have turned slightly negative.

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At this point in time, 85 companies in the index have issued EPS guidance for Q1 2016. Of these 85 companies, 68 have issued negative EPS guidance and 17 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the first quarter is 80%. This percentage is above the 5-year average of 72%.

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Poor guidance continues to come from IT and Industrials (mainly USD related) while guidance from consumer-centric companies has not worsened last week and is in fact better than last year at the same time. This is also confirmed by TR’s data which reveal that negative guidance is roughly in line with last year at the same time while positive guidance is somewhat better.

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At 1866, on trailing EPS post Q4 ($117.28 per TR), the Rule of 20 P/E is 18.0, offering potential upside to fair value of 2100 of 12.5%. This is normally pretty appealing. The last time we had such a good upside potential was in mid-2013, after equities corrected 9.2% during another growth scare after the end of QE3. Equities jumped 15% during the following 6 months to 1848 to reach 20 (fair value) on the Rule of 20.

Not that economic news got so much better. Just that earnings kept rising. Trailing 12-month EPS rose from $96.81 at the end of 2012 (fully reported at the end of February 2013) to $107.30 at the end of 2013, a 10.8% gain while inflation remained stable around 1.7%.

Looking at the next 6 months, S&P 500 company EPS are seen dropping 4.8% in Q1 and 0.8% in Q2 before jumping 5.7% and 12.0% in Q3 and Q4 respectively, according to Thomson Reuters (see PICK YOUR FACTS). So no earnings tailwind for another 6 months but, as mentioned, largely due to Energy and Materials.

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On the other hand, equities are undervalued currently and a change in investor psychology could result in a good rally given that the S&P 500 Index is now nearly 10% below its 200-day moving average of 2035. What’s needed now that U.S. recession fears are abating? Higher oil prices and better news from China. But tell me if you can forecast any with any degree of certainty.

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But equity markets are even cheaper than they appear. The absolute P/E on trailing EPS is now 15.9, down from a recent peak of 18.2 in December 2014. This compares with a long term average of 13.7 (since 1927 and 1953, 18.5 since 1993). However, the Energy sector P/E is currently 40x because of depressed EPS when it normally is around 12x. This abnormally high multiple artificially inflates the overall S&P 500 Index P/E by about 2 full P/E points meaning that normalizing Energy, equities are actually selling at 13.9x EPS, right on their LT average and very low considering current low inflation and interest rates.

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Applied on the Rule of 20, its current 18.0 reading drops to 16.0 with Energy normalized, meaning that fears about a U.S. recession, the oil rout, another banking crisis and the China syndrome have largely been factored in.

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U.S. equities have corrected 12.7% from their May 2015 peak when the Rule of 20 P/E reached 21.0 and are now deep into undervalued territory, close to their lows of 2010-2013. Since the March 2009 trough, the lowest reading on the Rule of 20 was 15.1 in May 2012. That was when the U.S. economy was sputtering (CBO warned of 2013 recession), Greece was reeling, Europe was sinking and China was slowing. It was just before the Fed announced it would continue Operation Twist and 2 months before Super Mario’s “Whatever It Takes” speech.

Equities rose 30% during the following 12 months even though trailing earnings initially flattened before easing 2% to their trough of June 2013. The whole rally was from expanding multiples which jumped 27% from 13.4 to 17.0 while the Rule of 20 P/E rose from 15.1 to 18.8.

Investors could again be reassured in coming weeks/months if:

  • U.S. recession fears abate;
  • the oil price strengthens as a result or even jumps under a supply agreement;
  • China does not implode and stabilizes growth;

Such events would likely more than offset the weak earnings trends in the first half of the year, building expectations for a better second half. Given recent data, recession fears should diminish. Given recent declarations by numerous OPEC and non-OPEC countries, an oil deal is possible albeit in no way certain given the poor relations between Saudi Arabia and Iran. Given the health of the U.S. consumer, a Chinese implosion is improbable over the short term.

Some of the best conditions for a meaningful rally are present: significant undervaluation coupled with very negative sentiment and media narratives. The drawbacks are that there is no earnings tailwind for a while and many technical indicators are not flashing positive. In particular, the 200-day m.a. is in a downtrend.

Regular readers understand that the Rule of 20 is not a forecasting tool but rather an objective measure of risk and reward. In the current circumstances, the upside is between +13% and +25% while the downside seems limited in a no recession environment. That said, these not so trivial risks that remain, justifying 3 stars rather than 4:

  • No oil deal and Iranian oil floods the world bringing prices even lower for longer.
  • Middle-East in turmoil. Russia in depression. Rising social and military tensions.
  • China keeps slowing and even devalues 10-15% exporting more deflation. Social unrest soars.
  • Central bankers lose control and experiment further with negative rates, pushing on strings while pressuring banks around the world.
  • Investor confidence craters: no leadership in U.S., Europe, Middle-East. Trump or Sanders becomes President!

The world is not a safe place, be it on geopolitics, economics or financial. Central bankers keep experimenting, openly unsure of the right course. The race to devalue is only matched by the race to cut interest rates as countries with weak economies are increasingly faced with rising social tensions and the rise of leftist politicians. China, the elephant in the commodity room, is struggling to find the right way to steer this immense vessel amid treacherous waters, learning on the go how to operate with opposing piloting methods.

Hence the opportunities from low valuations in a world of low interest rates and low inflation. Hence the need to remain prudent and not invest blindly. The blind spots are in commodities and global trade. The better visibility is in North-American consumer-centric companies and solid financials.

1 thought on “UPGRADING EQUITIES TO 3 STARS”

  1. Denis, a very interesting analysis. However, if you curve fit, or normalize, the Rule of 20 today for the energy sector, I think it should be broken out in a separate chart from your normal chart Rule of 20 chart.

    If you normalize for the energy sector today, logically, you probably should have normalized for the tech sector back in 1998-2003.

    Furthermore, you could make an argument for normalizing those financial stocks that were not permitted to be shorted in fall 2008. I recall lots of companies wanting to be financial stocks in October 2008 when the SEC and Treasury put in their ill-conceived trial of not allowing financial stock short selling. When a group of stocks had their own special trading rules, they probably should have been “normalized” for that time period.

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