Recap 9-7-12: Risk Rally Sustainability


PE expansion has essentially been the sole driver in this market. Over the past 3 months, the S&P is up 9.6%, 8.5% of which came from expanding PE, and just 1.1% coming from better earnings estimates. This is one reason why this risk rally has been perplexing for fundamentals based players, and less so for technical analysis based players, who don’t distinguish between the drivers. On a trailing basis, the S&P’s PE ratio is now within a hair of the March highs.

Over the near term, this is probably sustainable. The confidence effects following from QE announcements & improving data should last a bit longer. And my own indicators for PE ‘fair value’ do not suggest that it is too high yet. But obviously, P/E expansion alone can’t drive the market higher indefinitely. Better earnings will be necessary. And the outlook there remains challenging.

S&P profit margins peaked in Sept of last year, and have drifted lower since. This suggests that cost cutting measures have hit their limits. Consequently, further real EPS growth will need to come from expanding sales, which in turn will require stronger employment growth. Today’s payrolls print suggests that this is still not likely. Non Farm payrolls have averaged around 150k per month since early 2011, and have printed below that every month since March. Furthermore, the 4yr contraction in the participation rate to the lowest level since 1981 suggests hysteresis or demographic aging effects, both of which are negative for future employment growth. And of course, fiscal contraction is coming.

None of this necessarily suggests that the rally is at immediate risk. Corporations could well maintain low single digit top line growth for the foreseeable future. But prices and fundamentals do converge over time. As the risk rally progresses, it will be important to recognize how much of it has been built on sentiment, as compared to fundamentals.


  • China rallied 3.7% overnight after Beijing announced a 1 trillion yuan infrastructure spending plan ($158bn). The money will be used over several years
  • Intel cut their revenue outlook to $13.2bn, +/-$300mm, down from the previous guide of $14.3bn
  • US Non Farm payrolls declined to 96k in Aug vs 130k prev. Last month’s figure was revised lower by 21k
  • Unemployment declined to 8.1% from 8.3% as a result of a drop in the participation rate from 63.7% to 63.5%. The civilian labor force declined ~400k.
  • Both Hourly Earnings and Hours worked came in weaker than expected.

Upcoming Data:

  • Sun: China IP, Retail Sales, Trade Balance, Japan Current Account, Eco Watchers Survey
  • Mon: EU Sentix Investor Confidence, Australia NAB Business Confidence, China Money Supply
  • Tues: Canada Housing Starts, Trade Balance
  • Wed: UK Jobless Claims, US Import Prices
  • Thu: US PPI, Jobless Claims, FOMC
  • Fri: EU CPI, Employment, US CPI, Retail Sales

4 thoughts on “Recap 9-7-12: Risk Rally Sustainability

  1. Great recap and write up as always.

    I think its fair to say that p/e expansions during global contraction in PMI data combined with very weak payroll growth in the US suggests that its nearly all sentiment or better yet a concept that is entirely related to the fixation of QE. Its almost comical now that bad news is great for markets because the fundamentals don’t matter anymore. In times of recession/contraction p/e’s normally contract to ~10 but we are sitting at nearly 15x forward earnings because of the euphoria related to more printing – whether by the Fed, ECB and/or BOJ. It has been 4 years since the 2008 crisis and we have seen LTROs, QEs, Twists and Turns and nothing has been solved. I wonder whether more QEs and OMT (new LTRO) will do the trick because “its different this time”. We live in interesting times that is for sure.

    1. Thanks!

      Yes, it not clear how much of an effect the monetary easing has had. Or how much more it will have.

      After MBS purchases, they could buy some 15+ yr treasuries. And after that, they can target nominal GDP or Unemployment. But that’s probably it. I think even the most vocal Fed supporters would balk at Fed purchases of stocks or corporate bonds just to lower the employment rate.

      So the question is – how many more PE multiples will those add to the market? Diminishing returns, indeed.

      1. What are your thoughts on the decreasing supply of *good* collateral? It seems the central banks have a significant share of good collateral on their balance sheets and I wonder whether this will negatively impact the financial system (repo mkt etc) as an unintended consequence of QE because good collateral is scarce. Appreciate your thoughts.

        1. I can’t claim to have a lot of insight into that.
          I think the requirement for good collateral is a function of the level of systemic leverage and available deposit guarantees. (including deposits at the Fed)
          In that respect, the US doesn’t look like it will have a shortage. Banks are delevered, and they have massive deposits at the Fed.
          The EU of course is another matter. But the ECB backstop of peripherial front ends has probably eased the shortage somewhat. The backup in schatz yields support that view. What could really screw that up, however, is if the ECB cuts the deposit rate to negative levels. That would probably INCREASE leverage as EU banks try different ways around that. (repo, swaps, etc) Hopefully the ECB won’t do that.

          My 2 cents… take with a grain of salt like with everything else!

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