You would think with the way that CNBC handled the earnings releases this week (starting with Alcoa) and then the earnings pre-announcements from Cummins (CMI) and such mid-week, and with Bespoke as well as S&P Capital IQ hammering on the “dour and poor guidance”, that we should be digging bomb shelters and storing canned goods, but you can imagine my surprise on Friday afternoon, upon reading the latest weekly earnings update from ThomsonReuters, that the “forward 4-quarter” earnings estimate for the S&P 500 rose to $111.88, from last week’s $110.94, despite Alcoa’s earnings release, despite Cummins (CMI) warning, and despite Applied Materials (AMAT) and a host of others, issuing weak or poor guidance.
For someone who thought the q2 ’12 earnings season would be ok, given the dour sentiment, it was still quite a surprise to see the $111.88 number from ThomsonReuters. The total “forward estimate” increase for the S&P 500 as we have rolled into July is $4.63, or roughly a 4% increase from the $107 estimate at the end of June.
Prepared for something far worse, particularly since individual company negative revisions continue to outnumber positive, I still think q2 ’12 earnings will not only be ok, but will demonstrate that the bearish sentiment is out-of-whack with bottoms-up company fundamentals, within the S&P 500.
What’s more, reading our weekly review from Bespoke, most “market/investor sentiment” gauges are at or close to multi-year lows, including the “strategist recommended equity allocation” which is sitting on its 5-year low. In other words, Wall Street Strategists have the lowest percentage weighting to equities currently, as measured over the last 5 years. Conversely, we remain overweight equities in client balanced accounts and tilted more aggressively to US equities given the valuation and risk / reward.
At $111.88, the S&P 500 is now trading at 11.5(x) forward earnings estimates, about 30% below the 15-year average p/e for the S&P 500 of 16(x) – 17(x).
Revenue growth for q2 ’12 was revised from 2% last week to flat or 0% this week, pretty much all of that on the energy sector being revised lower.
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We were fortunate enough to get invited to JP Morgan’s Investment Forum in Chicago this week, where Dr. David Kelly, JP Morgan’s Chief Economist spoke. We could only hang around for his presentation, but here are some of David’s nuggets of wisdom left with the audience:
1.) The US will likely not fall back into a recession in 2012. US GDP growth has averaged 2.4% off the March ’09 bottom, while private sector growth has averaged 3.3%, so the reader can quickly see the drag the public sector is having on the economy, but we still wont see a recession. (Remember, a recession is defined as two consecutive quarters of negative GDP growth, so we could still see one quarter of negative growth and not see a recession. But with the housing recovery I doubt we’ll even see one quarter of negative growth.)
2.) Housing starts are still less than half of the 30-year average of 1,400. The housing recovery is just getting started;
3.) The US budget deficit is actually shrinking (in other words progress is being made despite the slow-growth economy), but the expected CBO Baseline projection of -3.8% (deficit as a percentage of GDP) given the “fiscal cliff” is too much too quickly, from the current -7.8% percentage. David thinks that President Obama (if re-elected) will temper the austere measures of the pending fiscal cliff;
4.) The capital gains and ordinary income tax rates will rise in 2013 for investment-related gains and income (per David) probably to 20% for capital gains, and dividend income. Most pundits I’ve heard are expecting at least 20% next year, which is affecting our trading this year for client accounts (more discussion on this topic below under the “trading update”);
5.) Europe is “priced for ugly” but the euro will stay together. David thought that EFSF would fix Ireland and Spain first ( I didnt understand some of the mechanics of the discussion here) and essentially back the bank debt and then the sovereign debt, but it will be a bumpy ride over several years. The two choices Europe faces (per David) are 1.) Unite the fiscal policies, or 2.) Split up and dissolve the euro. He thinks the euro stays together.
6.) Don’t trust the Chinese GDP numbers;
7.) The Treasury market with negative yields on the 10-year and 15-year TIPS is the most distorted, twisted market David has seen since the Nasdaq in March, 2000;
8.) High yield bonds still look relatively attractive (we agree and have been overweight credit for a while);
9.) And last, but surely not least, my favorite stat of the week, David Kelly noted that the “earnings yield” on the S&P 500 on July 6th of 8.20% “was higher than 99% of days since 1962”. It is even higher this week, from 8.19% on July 6th to 8.25% as of July 13th (and that includes Friday’s rally). Jeff Miller of “A Dash of Insight”, Doug Kass and I have written about the earnings yield of the S&P 500 on more than one occasion. (See our May 20th blog post and the comparison of 1999’s 3.5% earnings yield with the 6.5% Treasury yield on the 10-year back then, to today’s earnings yield and 10-year Treasury.) The Fed model worked back then, can it do so now ?
To repeat: Record high “forward 4-quarter” earnings estimate for the S&P 500 at $111.88, combined with close to or record low investor sentiment.
How are you invested ?
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Trading update: We added to JP Morgan on Friday after their earnings release but are still working through the numbers. What caused us to add to our position was when Briefing.com reported that Jamie Dimon said on Friday’s conference call that 2012 would see “record earnings for JP Morgan”. Since 2011’s actual earnings were $4.48, even if just assume JPM does $4.50 this year, you could nominally make the case for 10(x) p/e on $4.50 earnings or a $45 fair value price. My own calculation was that – assuming some volatility and uncertainty around earnings – JPM is worth at least the low $40’s or a 20% increase from Friday’s close not including the dividend. (Long JPM and WFC)
Morningstar’s fair value on JPM is $51 per share.
Healthcare continues to power ahead. Merck (MRK) and Pfizer (PFE) are our two biggest holdings, but we also have a little bit of AMGN. Merck rose 8.72% in the 2nd quarter, (excluding the dividend) while Pfizer rose 1.55% (also excluding the dividend). Merck seems too overdone and stretched technically here, so we added to Pfizer on Friday. Both MRK and PFE sport 3.9% dividend yields. Our favorite pharma and biotech analyst, Mark Schoenebaum of ISI, thinks that very little value is being given to either drug pipeline at MRK or PFE. Mark thinks PFE worth $27 – $28 and MRK is worth $47. (Long MRK, PFE, AMGN, and adding to PFE of late)
Alcoa – we took the loss on our Alcoa in brokerage accounts, but kept the position in IRA’s and other tax deferred accounts. The stock was down heavy on Tuesday – over 4% on heavier volume – following its Monday night earnings release, and is testing its multi-year low near $8.21. It doesn’t look good, probably due more to China being wobbly. If the Shanghai market breaks support here, i would think Alcoa will get dragged down with it. This value play is turning into a value trap. AA is cheap on a lot of metrics, but the 2012 consensus eps estimate has been cut to $0.37 per share. Wow – can it get any worse ? Morningstar has an intrinsic value on AA of $19 per share so the stock is selling at 44% of one firms fair value. (Still long AA, just a smaller position. )
Walmart still looks good – stock is still above its 12-year breakout of $70.25. Still extended technically. We wouldnt add to it here. Target doing well too. Return to the discount mass merchants ? Sure seems like it with Costco near $95. Wouldnt buy any of these stocks until they correct. (Long WMT and small position in COST – waiting for a pullback.).
The 10-year Treasury nearing it’s early June low of 1.44% yield. Hit that same level in 1944 (not a typo) I think. Note the 1.44% yield in June 2012, coincided with the S&P 500 touching 1,260 in early June, and NOT on the weak economic data.
We are still overweight high yield in client accounts. We like the 6% – 7% yield, and with all the corporate cash and the central bank liquidity, credit is an easy decision here. Plus high yield gives us some duration (interest-rate sensitivity) cushion in the event of sharply higher rates.
Because most expect higher investment taxes in 2013, we are taking a combination of more losses and more gains in taxable accounts in 2012. I wonder if – with the higher expected cap gains rate – if a tax-loss carryforward in 2013 will be worth more to a client given the higher cap gains rate ? I would assume so.
I am out on a limb here but i think we are in the top of the first inning of a 9-inning ballgame regarding the electric car. A huge game changer for crude oil and gasoline (energy), the auto industry and the electric utility business. The www.thestreet.com had a good article this week on the number of electric cars sold (Jim Cramer referenced the article in one of his tweets), and market share currently is roughly 1/2 of 1%. I think the electric or plug-in is like the PC in 1980 – it is just a matter of time. Cost needs to come down and mass production needs to improve, which are not mutually exclusive events. Better battery function particularly for cold weather climates is critical too, and progress is reportedly being made in that area. Gasoline will come back to $1 a gallon. Energy, auto’s and electric utility’s are what percent of GDP do you think ?
We are overweight US equitities in balanced accounts 65% – 70%, and remain overweight credit in the fixed-income portion of client accounts. We’d be wildly bullish if we knew what the outcome was of the US Presidential election and if Europe could just stabilize. I think if we could get away from this anti-business, anti-wealth, anti-financial rhetoric and free-up the US economy, i think we could see a series of years for the S&P 500 reminiscent of the early 1980’s.
However, Ive been called an idiot before (early and often too).
Corporate earnings are sending a good signal, as is investor sentiment.
Be sure and check www.seekingalpha.com for our earnings preview on various companies. Last week we previewed Alcoa, JP Morgan and Wells Fargo. This week we will preview a handful of others as well.
Thanks for reading.
Trinity Asset Management, Inc by:
Brian Gilmartin, CFA
Portfolio manager