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Kass: Fair Market Value Update

As of a week ago, 115 S&P 500 companies have reported third-quarter 2012 results. If we take out financials, the year-over-year earnings change has been down 2.5%, slightly ahead of consensus but representing the first decline since third quarter 2009. According to Street sources, 59% of the companies have beaten expectations. A year ago, 69% beat expectations. This (59%) is the lowest percentage beat since the recovery began three years ago, well below the 72% average since the profit recovery began and in line with the long-term average of beats to consensus forecasts. By contrast, 27% of the 115 reporting companies have missed relative to expectations compared to only 21% in the year-ago third quarter. This compares to the long-term average of 19% of the companies missing relative to expectations.

On the revenue side, the results have been particularly weak, with the average company reporting only 0.4% year-over-year growth and up 2%, taking out financials. Sales growth is missing consensus by 1.3 points, and just 28% of the reporting S&P 500 companies are beating sales consensus while 51% are missing.

I expect weak nominal GDP growth in the U.S in 2013. This, coupled with a recession in EU and further deceleration in emerging markets, suggest that the sales and profit weakness in third quarter 2012 will be with us for some time to come. It is for this reason that the market's upside appears limited, even though central bankers around the world are injecting an avalanche of liquidity.

U.S. real GDP expanded at about a 2% rate in the just-concluded quarter, a slight reacceleration from the previous three-month period. But, with rising gasoline and food prices, a weakening in refinancing activity, political uncertainty and fears of a fiscal cliff, aggregate growth will be hard-pressed to improve from the 2% growth rate in fourth-quarter 2012.

Today's new fair market value calculation of 1415 incorporates the following:

  • There is no change in the probabilities in my scenario analysis.
  • Reflecting the continued and surprisingly low-interest-rate environment, I have modestly increased the P/E ratios applied to each of the four outcomes.
  • Profit forecasts for 2013 are being revised slightly lower in light of actual third-quarter results, weakness in sales and generally punk guidance.

"Investing is an art form that requires probabalistic decision-making using imperfect information about an inherently unknowable future."

-- Barry Ritholtz, The Big Picture

Since I began this exercise I have tried to be consistent with methodology, reasonable in my profit forecasts, and I have applied sensible valuations. Again, I want to emphasize that my methodology, though appearing precise, recognizes the difficulty of attaining investment precision given the numerous moving parts (economic, interest rates, sentiment/psychology, political outcomes and other exogenous factors) in its calculation. It is intended more as a thoughtful guideline (of reasonable expectations/outcomes) than an exercise that should be taken literally. (I strongly recommend that subscribers input their own probabilities and outcomes in order to produce their own market expectations.)

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