Archive for October, 2012

S&P 500 Fair Value

Tuesday, October 23rd, 2012

S&P 500 Index

I wrote to our clients with their September 30th Quarter-end statements that I was getting uncomfortable with the market and how high it had gotten. At the time, and it continues, I was worried about the potential earnings from companies not living up to expectations.

So far, earnings season has been pretty difficult. Many of the large S&P exporters have been hurt with revenues below estimates for the quarter due to the high level of the dollar.

We had been raising cash going into earnings season as a precaution against any sort of correction due to expectations not being met.

Now that we are well into earnings season, I wanted to calculate for you what a reasonable assessment of the Fair Value of the S&P 500 might be:

Fair Value Range

In the chart above, you can see that I have calculated a low-end and high-end range based upon several factors of the S&P 500: the historic compound annual growth rate, the earnings growth rate, actual trailing 12 month earnings, projected future 12 month earnings, and a discount rate.

I then used those calculations as inputs to a Future Earnings Discount Model to derive a fair value range of 1302 to 1455 on the S&P 500. The low-end of the range represents a 9% downside and the high-end of the range represents a 2% upside to current levels on the S&P 500.

This is a dynamic model with the inputs changing constantly, but it gives me quantifiable method for determining when the market is getting ahead of itself and when it is lagging its fundamentals.

The fair value numbers are only as good as their inputs, and with the earnings from the multinationals coming in below estimates, I am seeing the top-end come down on a daily basis right now.

Given that I have been in the business for nearly 30 years, I get gut feelings on certain things just by watching the flows of money into and out of the market as well as how the markets act vis-a-vis their trend. So I like to do a gut-check against this quantifiable model at times like this just to make sure the numbers are paralleling my observations.

The market has risen significantly, and we are very close to the top of the secular bear market trading range discussed a couple days ago on the blog. So, it is not surprising that we are seeing some pullback.

I’ll be back on the blog with more as earnings season unfolds, but I wanted you to get a feeling for where we were from a valuation point-of-view relative to the news coming out of earnings season.


QEternity, the Federal Reserve Policy’s Implications

Friday, October 19th, 2012

S&P 500 Long Term Trading Range

The stock market ran higher after the Fed’s announcement of its most recent monetary policy position. Prices were up largely due to Federal Reserve liquidity and the announcement that their Quantitative Easing policy, known as QE, will be extended with no known end date.

This QE program, which I am calling QEternity due to its not having a known stopping point, allows for the purchase of $40 billion of mortgage securities each month in order to continue to add liquidity to the US monetary system.

Several days prior to the Fed’s announcement, the European Central Bank announced a bond purchase plan to help boost the struggling European economies by providing liquidity to countries that were having trouble finding buyers of their debt. The world is awash in liquidity in the hope that it will generate some economic growth. Unfortunately, the economic headlines continue to give mixed signals for investors and businesses alike.

As we look toward year-end and into 2013, I am growing increasingly concerned with the level the S&P 500 has achieved. If you look at the graph above, you will see that we are approaching the top of the long-term trading range that we have been in during the current secular bear market. Given the current economic malaise in our country and in China, combined with the recessionary economies in Europe, I cannot see the S&P 500 starting a new secular bull market. I just do not see a catalyst to drive earnings significantly higher nor to entice investors to pay more for earnings.

The current P/E ratio for the S&P 500 is about 14, or roughly 10% below the historic average of 15.5. Investors are just not valuing corporate earnings to the same levels as they have in the past. Plus, earnings growth numbers for the companies in the S&P 500 on average have been decreasing over the past several quarters (please understand, this does not mean earnings are shrinking, only that the rate of growth is less than two years ago). In fact, today we saw several companies punished for lowering their earnings growth expectations: McDonalds, GE, Microsoft, and Google to name a few.

The Federal Reserve’s policy of printing money through Quantitative Easing (we’ve had the original QE, QE2, and Operation Twist preceding QEternity) has certainly pushed stock prices higher the past couple of years, but each iteration of that policy has had increasing less impact on the real economy. If you look at Japan which is on their eighth version of a QE program, their economy has been at stall-speed for a couple of decades with little permanent impact from QE related stimulus.

I just don’t see that this policy will drive economic growth in the US significantly higher – it should keep us out of recession but only provide for slow economic growth (maybe in the 1.5% GDP range) and it will likely have little impact on lowering unemployment. I also do not see it as a long-term stimulus to the cyclical stocks like we saw immediately after the Fed announcement – the cyclical stocks are perceived to be attractive when the economy is heating up, and we will likely be in a more slow-growth mode instead of in the midst of an economic flurry.

To start a new bull market in stocks and break out of the long-term trading range, we will need some sort of macro event or fiscal catalyst: the 1980’s had the Reagan tax reforms and the fall of communism; the 1990’s had the peace dividend, commercial use of the internet, and the Clinton balanced budget; and the 2000’s had the Bush tax cuts. These sorts of items have huge implications that stimulate the economy and provide for economic development and falling unemployment. Unfortunately, there aren’t really any of these caliber items on the horizon, so it is left to the Federal Reserve to keep enough liquidity in the system to facilitate the slow growth we have.

Does that mean we are headed for a Triple Top in this trading range? To have a new bull market start, we will need to break out above the top blue horizontal line and remain there on a sustained basis. That will take some sort of macro economic event or some major fiscal policy from Washington that fixes our economy, putting our economy on a much higher growth trajectory.

Because of the uncertainties ahead of us, we have been raising cash and getting more conservative in client portfolios. This means we have been using the post-QE rally to sell more volatile holdings, smaller capitalization holdings, and any holdings that we think might have profitability issues in coming months.

As we head into year-end and further into 2013, we will be focusing on companies with strong balance sheets, with low valuations compared to their growth prospects, and with shareholder friendly dividend policies. We believe that all of these attributes will be in favor – whether the company is large-cap or small-cap, foreign or domestic – and those companies should outperform other companies that are of lesser quality in a slow-growth economy like we anticipate.


Is Apple the New Walmart?

Thursday, October 18th, 2012

Apple Chart

Just a quick note on a stock that everyone seems to follow. If you look at the chart above, you can see that I have charted the stock price of Apple since early May compared to its 50-day moving average (the solid red line) and the S&P 500 (the solid purple line).

Apple, being the largest stock in the S&P 500 Index and being up 55% year-to-date, has been responsible for 5% to 7% of the S&P 500’s increase this year. However, from the chart above, you can see that the two have parted company and that Apple has fallen below its 50-day moving average.

Expectations for the iPhone 5 were sky-high, and when Apple didn’t meet them – particularly with their Maps fiasco – investors sold the stock off from its all-time high around $700 and booked profits.

A 10% pullback after the run it had should not be surprising, but its total sales numbers for the iPhone 5 during the 4th quarter will be key to whether it will trade side-ways for a significant period of time (See the Walmart Chart that follows) while it waits for a new catalyst.


The last stock that I remember acting like Apple has the past few years is Walmart in the 90’s. You can see that Walmart had an equally meteoric rise higher, corrected, then plateaued for 12 years as its earnings caught up with investor expectations.

Could that happen to Apple? Well, Apple’s valuation is no where near as high as Walmarts from a P/E perspective – but from a Price/Sales perspective, the valuation is pretty high. But it could certainly happen – there are many similarities to Apple today compared to Walmart in the 90’s – everyone owned
Walmart and no one wanted to sell it. They continued to expand and grow their earnings, consistently beating prior quarters and expectations. But eventually, each new store made a significantly smaller impact on the bottom-line.

Then, they hit a time where they just couldn’t meet the expectations of investors, and it took 12 years for valuations to become reasonable compared to the market and their earnings.

Only time will tell if Apple is at that point where each new product is having an increasingly smaller impact on the bottom-line. Combine that with Steve Jobs no longer being with the company, and it should give investors some caution.

For those investors that have racked up > 800% gains by holding the stock the past few years, booking some profits might be a good strategy. You never know what Mr Market has in store for you since your returns depend so much on the sentiment of other investors.

If everyone else turns on Apple and devalues it, you are the loser even if it continues to earn a lot of money – the result is that even though its sales are significant (as Walmart’s were for years) investors are just not willing to pay as much for those sales and the price goes down, bringing the price/sales ratio back in line with the market.

The 4th quarter will be key for Apple (as will its impending deal with China Mobile to offer the iPhone through China’s largest cellular company for the first time), so this is one to keep your eye on and not lose the profits you’ve gained over the years.