Over the last couple of weeks, there’s been a growing sense that QE2 will not be shock & awe, but may instead be more modest and measured.
What’s interesting is that the news has mostly been bad for commodities and Treasuries. Equities have mostly been able to hold up (though the rally has definitely seen its momentum come to a halt).
So if QE-lite is actually what we get, where do stocks go?
Mike O’Rourke of BTIG argues that bullishness is still the proper stance:
Here is the reason why we believe equities will be the winner if investment objectives are reset as a result of a QE disappointment. Although the investment community is playing QE through various other markets, anecdotally, it seems as though equities are the assets investors want to sell first. In making such sales, investors will need to look at the underlying fundamentals behind the S&P 500. According to Standard & Poor’s, current estimates for 2010 are $83.63, and according to Bloomberg, they are $84.58. Peak earnings for the S&P 500 were $87.72 in 2006, the second best year was 2007 at $82.54. With more than 3 quarters of the year already in the books, there is a notable likelihood that 2010 will be the second best earnings year on record. It will only take 4.5% earnings growth in 2011 to set a new record for S&P 500 earnings. As many investors know, current estimates, which are likely to keep coming down, are for 12.8% earnings growth or $94.30. In such a fragile economic environment, investors are being responsible and conservative and are not putting too much faith in that number. According to the S&P, another interesting stat is that cash on the balance sheets of the S&P 500 Industrial-Old (which is the S&P 500 minus Financials, Utilities and Transports) is equivalent to just over 10% of market capitalisation.
If equities experience a pullback of 5%-7%, then based on 2010 estimates, the index will be trading 13-13.3x earnings. If we factor in any portion of that cash hoard, then they are looking at a market between 12.5-13x earnings. If we factor in a very conservative 4.5% (considering estimates are 12.8%) earnings growth for next year, then they are looking at a market trading 12.5-12.75x earnings. Again, when one thinks about the high levels of cash, then the market is closer to 12x forward earnings. A market trading at such multiples is hard to short. Every piece of positive economic data will send shorts lacking conviction scrambling to cover positions. If the market does wind up disappointed by the Fed, and there is a correction, it is likely to be short lived. As the result of such movement, as capital flows out of “speculative” QE trades, we suspect many investors will recognise what an excellent “investment” opportunity the S&P 500 is.