Gill Capital Partners' Views on Equity Valuations and Earnings

Equities: The first half of the year was characterized by the large disparity between the performance of US equities and the performance of nearly all other asset classes: whereas the S&P500 got off to its best start since 1998, nearly every other major index posted mediocre results.  The largest detractors to performance were emerging market equities and commodities, both in negative territory:

Returns for Major Indices:
	YTD	QTD
S&P500	18.07%	3.63%
MSCI EAFE	12.35%	7.79%
MSCI Emerging Market	-8.98%	2.25%
DJ UBS Commodity	-8.00%	4.25%
	*As of August 15, 2013

The third quarter, however, has rewarded ex-US indices with outperformance, highlighted by a quarter-to-date gain of 7.79% in the MSCI EAFE.  Much of the gains have come from a compression in valuations: the S&P500 and MSCI EAFE are both heavily weighted toward large cap global companies that source their revenues globally; however, the average PE in the S&P500 is 18.6 whereas the average PE within the MSCI EAFE index is 14.97, even after the 7.79% run-up over the last six weeks.  Assuming earnings for both indices are flat, the MSCI EAFE would have to appreciate by 24.25% to match the S&P 500’s valuation.

Earnings:  Earnings season continues to be characterized by stagnant revenue and modest earnings growth.  As of August 16, 464 of the companies in the S&P 500 have reported earnings, with 72% of the 464 companies beating the estimate.  Nevertheless, only 52% of all companies beat revenue estimates.  Keep in mind both consensus estimates were downwardly revised throughout the quarter. Companies continue to maximize margins through operational leverage, price controls, and cost controls.  Of course, the only sustainable way to consistently generate earnings growth is through revenue growth, something few companies are accomplishing this quarter. Although earnings are still growing, the 2.1% pace is underwhelming and reflective of overall GDP growth.   The forecast trend is troubling considering current valuations: so far, 75 companies have offered negative Q3 guidance, while only 17 companies have issued positive EPS guidance.  Although valuations don’t look overdone at the moment, the forward P/E (given consensus analyst estimates) is currently at 14.2, slightly above the historical    average of 14.1.  Given the S&P 500’s impressive run over the last six months, earnings may have to catch up with the price if the rally is going to continue.