As Sam Sees It: Investors Are Undervaluing Stocks as Wall Street Expects Third Quarter Trough

Sam Stovall  |

Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.

EQ: In this week's Sector Watch, you discussed the Rule of 20. What is this metric and what can it tell us about the market?

Stovall: The Rule of 20 is a very old and very simple metric used to decide if the market is cheap, expensive, or fairly valued. Simply stated, if you take the trailing 12-month price-to-earnings ratio and add in the inflation rate, a result of 20 would imply that the market is fairly valued. An amount less than 20 indicates that the market is undervalued and an amount higher than 20 implies that the market is overvalued. Since 1948, the interesting thing is the S&P 500 has traded at a median level of 19.8, meaning that in every quarter going back to 1948 the average has been within 1 percent of what is regarded as a proper reading. I find it pretty interesting that the Rule of 20 does end up holding as a good measure for market valuation. However, when you look at a chart, you can also see that there are many times the market ends up being expensive or cheap, but in the long run, the rule ends up being a relatively good market valuation metric.

EQ: If the rule proves true again, what does that mean for stocks based on where we are now?

Stovall: Right now, with the P/E for trailing GAAP earnings at 16.3 and the inflation reading rate at 1.9 percent, what we find is this level is around 18.2, implying that we are undervalued by about 10 percent. So the Rule of 20 is indicating fair value should be around 1575 for the S&P 500 rather than the 1435 level most recently.

EQ: One of the major concerns for U.S. investors has been China's ability to engineer a soft landing. With the Chinese stock market falling as hard as it has, does this raise any concerns for investors going forward?

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Stovall: It does raise a concern. However, I recently spoke with Lorraine Tan, S&P Capital IQ’s Director of Research for Asia, and she thinks China’s third quarter real GDP growth will probably be similar to what we saw in the second quarter, meaning a sub 8-percent level. While she is expecting a bit of a pickup in economic activity in the fourth quarter, we probably won’t really start to see an improvement in the overall economy until the second quarter of 2013. What she also says is that Beijing will probably be content with an upper-7 percent growth area, specifically 7.8 to 8 percent growth over the next year or so. This is perhaps because China is aware that there is only so much they can do given the ongoing debt crisis in Europe as well as the fiscal spending concerns in the United States. So China does not want to follow a similar path as Europe and the U.S. where it has to deal with excessive liquidity and its consequences.

EQ: Earnings season is less than two weeks away, followed closely by the presidential election, and then the fiscal cliff deadline. Is Wall Street preparing to return to the herky jerky movements we saw prior to the summer months? Or do you think the market has priced in most of its expectations?

Stovall: I believe that the market wants to work its way higher. There has not really been anything new thrown at the market, simply a rehashing of concerns surrounding the upcoming election, the fiscal cliff, and basically all the things mentioned above. We’re approaching the third quarter reporting period and S&P Capital IQ consensus estimates points to a 1.9-percent year-over-year decline, but at the same time, the third quarter is expected to be the troughing quarter. So instead of getting the 7.5 percent that we saw in the first quarter, the sub-1 percent we got in the second quarter, and then this negative result we expect in the third quarter, the feeling is we could start to see an improvement in year-over-year earnings numbers into the fourth quarter of 2012 and as we head into 2013. So maybe what the market is discounting is a trough in the latter part of this year with more reasons to be optimist as we head into 2013.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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