Economic Reality is setting in

by Wayne Ferbert on September 23rd, 2013

The Fed move last week to delay the taper indefinitely was a surprise to the market. But I like what Bernanke has done – he has given the market a wake up call. He has also helped ensure that there is still some uncertainty in both the economy AND in monetary policy.
 
In the end, uncertainty in the market is good for creating buyers and sellers. Every market needs both buyers and sellers for the market to act in a healthy manner. Any market that only has one or the other is doomed to create opportunities that institutional players are better poised to take advantage of. But a healthy group of both buyers and sellers helps to level the playing field for everyone.
 
When I look at the broader markets, I really think Bernanke and his Fed counterparts are making the right decisions here. GDP growth is still low at 2% compared to a healthy and robust economy where we would experience 3%+ in GDP growth.
 
And the markets have come so far in such a short period of time. In the end, I am a value guy and the S&P500 over $1700 just seems overbought relative to the earnings power of the companies in that index. Here are some of the facts in that index:
 
Standard and Poors at the end of August reports that the end of year 2013 EPS for the S&P 500 is estimated at around $108. The 2014 estimate for EPS is $122. This means the 2013 PE multiple at that time (S&P at 1633 at the time) was 15X. The forward PE for 2014 would be 13.3X. At today’s 1700 price on the S&P 500, this multiple is even higher, of course!
 
Let me ask you a question: do you think that EPS in the S&P 500 is poised to grow by 13% in 2014 over 2013 - ie, from $108 EPS to $122? GDP growth is around 2% right now. How does 13% EPS growth jive with 2% GDP growth? It doesn’t.
 
You would have to be a big believer that revenue growth and real business growth is coming to believe the $122 in S&P500 EPS for 2014. Let’s remember – many businesses in the S&P500 have business models that scale very efficiently. If they can achieve 4-5% in revenue growth, then the 13% EPS growth is very achievable.
 
However, the trend in revenue growth is going the wrong way. Revenue growth for the S&P 500 in the current quarter has been revised downward several times in the last 2 months and is now below 3%. That kind of revenue growth is not going to kick-start EPS.
 
In fact, the expected EPS for the current quarter has been revised down according to the tracking by FactSet. FactSet reports that the earnings growth estimate for Q3 was 6.5% on June 30th. As of last week, it now stands at 3.4% - or almost a 50% decline in. And companies that have pre-announced this quarter have overwhelmingly been warning as 80% of them have revised down.
 
My co-author pointed out to me earlier today that the original estimates for the effects of the sequester spending cuts said that the impacts wouldn’t really begin being felt until the 3rd calendar quarter. Well – here we are!
 
There is no way to spin this – the economy can not really justify these valuations TODAY. Now we know the market often puts a price on assets with a real forward outlook so we are not saying the market can’t stay around this current price. We think it can. We are just hard pressed to see any large institutional long-term buyers come in and drive this any higher.
 
As a result, we like setting your new hedges now – and looking to sell calls closer to the money than you ever have before – at least with a 6-9 month outlook.


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