Portfolio Update

The market is dynamic. It is the sum of millions of emotions boiled down to a single stock tick. So while we have attempted to capture those emotions mathematically through our tactical behavioral modeling, an investor should not forget the fundamental basics and the importance of corporate earnings.

We have been reading much on the coming slowdown in earnings growth. Reports from S&P Capital IQ indicate 2012 earnings growth expectations for the S&P 500 are 6%, down from 16% in 2011. In fact, earnings for the S&P 500 grew at an 8% pace in 4Q11, the slowest in two years, and 1Q12 earnings growth is expected to grow only 1%.

Profit margins are also expected to decline in 2012. In 4Q11, profit margins dropped to 8.6%, the first drop in over a year, and some analysts’ expect margins to deteriorate closer to the historical average of 7.2%. Margin expansion has been a huge part of the corporate earnings boom over the past several years as companies in the S&P 500 grew their bottom lines by over 70% on just over 20% growth in revenues. Playing the Profit Wave – Joe Light – Wall Street Journal.

Bottom Line: It is clear that corporate earnings will suffer a slowdown from quarters past and margin expansion will start to deteriorate from this point forward.

How will this earnings slowdown affect stock prices?

While the scenario that was just presented appears ominous for market returns, our belief holds that we will be seeing a major continuation of the bull market that began in 2009 (after a much needed pull-back from recent levels).

To address corporate earnings, the market is very forward thinking in its digestion of corporate earnings outlook. There has been little correlation between annual earnings grow for the S&P 500 and market returns. According to research produced by Doug Ramsey at Leuthold Group, of “the 16 best years for stocks, eight actually coincided with declines in corporate earnings. And profits rose in 13 of the 16 worst years for stocks.” Tables Have Turned for Corporate Earnings and Stocks – Paul J. Lim – New York Times.

It is for this reason that we at JSK Partners tend to ignore the month-to-month and quarter-to-quarter changes in earnings projections and focus on the forward twelve months of earnings expectations.

Bottom Line: For all the talk of the coming slowdown in corporate profits, that has very little to do with the actual direction of the market.

What to expect from corporate profits.

We have seen a very dramatic improvement in the corporate earnings picture since the start of the year and it has really accelerated in earnest since the official launch of the 4Q11 earnings season. As of last Friday, analysts are forecasting $107.84 for the S&P 500 in the coming twelve months. That’s up from mid-$106’s at the start of the year.

This increase in the twelve month forward earnings per share forecast is very encouraging in light of market valuations. Given Friday’s close of $1370, the twelve month forward P/E ratio stands at 12.7x. This stands in stark contrast with the seventeen year historical average of 15.0x, the trailing ten year average of 14.6x and the trailing five year average of 13.2x.

Using these historical valuation measures, one would place a twelve month price target for the S&P 500 within a range of $1420 to $1613, some 4% to 18% higher, respectively. Using an average valuation, we are placing a fair value target on the S&P 500 of $1533 or 12% higher than Friday’s close.

Bottom Line: Based on the recent corporate earnings trends, we expect additional upside from current levels (again, after a brief pullback over the next six weeks).

Our Fundamental Model

Fundamentally, the US stock market is undervalued and quickly approaching a buy point that will start a long-term rally. We are confidently making this call based on the fundamental research we have calculated and analyzed.

Our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices. The key elements within our fundamental model focus on:

1 - The twelve-month forward earnings yield for the S&P 500 (which is the inverse of the twelve-month forward P/E ratio).

2 - Expected earnings growth over the coming twelve months.

3 - Yield differential against the ten-year treasury yield to attempt to capture security rotation.

Our Fundamental Analysis

We have been tracking this model for over fifteen years and it has produced significant market directional opportunities. Unlike our behavioral model that seeks out more shorter-term directional movements in order to capitalize on excess returns through tactical portfolio rebalancing, our fundamental model provides information on larger secular shifts in the US equity markets and directs our strategic positioning.

When interpreting the fundamental model, one needs to wait for the trigger line (thin blue line) to fall below zero and buy when the trend line (thick orange line) starts to head higher.

As can be seen we are below the zero line and the trigger line has turned higher. This puts us on alert that we are approaching market bottoms and will increase our long exposure more aggressively when the trend line heads higher.

When following these rules of engagement, our fundamental model has picked points in the market when the US equity indices have gone on to return 28% on average in the following year.

We are extremely energized by the opportunity the market will offer us once we have confirmation in the fundamental model. Our anticipation that it will happen sometime in the first half of the year, possibly after one more pull-back for the S&P500.

Bottom Line: We are taking some profits off the table at this point and building cash over the next four to six weeks. After we get a much needed pullback in the S&P 500 (say 5% to 7%), we will aggressively move back into the market and take advantage of the coming rally.

Quick note on last week’s market action

We were convinced the aggressive sell-off at the start of the week was the start of what would be part of a larger decline. We were amiss in our analysis as the market seemed to brush off the negativity and continued higher the very next day.

We still believe, based on our behavioral model that a near-term downward adjustment is on its way. Notice the chart of the S&P 500 in figure 4. Two items to note, the volume on the down days exceeds the volume on the up days and the divergence between pricing and volume. This lack of buying volume indicates lack of conviction on the part of bulls and is a negative for the markets’ near-term, in our opinion.

Bottom Line: We are very pleased with our YTD performance and will be patient in waiting for the appropriate signals from our market models before moving back into the market from our current conservative position.

Joseph S. Kalinowski, CFA