Jul 13, 2012 | Post by: Roman Chuyan, CFA Comments Off on Turning Positive on U.S. Equities

Turning Positive on U.S. Equities

As of June 30, 2012

  • The Performance Analytics’ PAR Model ™ changed to a positive stance in June, with the six-month expected return for the S&P 500 of 3.1%.
  • Accordingly, we are changing our recommendation to an Overweight to public equities – a change from our Underweight recommendation that was in effect in the last three months.
  • All our model active allocation strategies outperformed the S&P 500. The 100%-Switching strategy outperformed by the most in the quarter, 2.87%.

S&P 500 6-m expected return:         3.1%
Recommended allocation:               Overweight
Prior month                                        -4.4%
Change                                              7.5%

 

Significant Factors

The P/E ratio is one of the key measures of index valuation in the PAR Model ™. It continues to extent a significant positive contribution to the model’s expected return, at 0.9 standard deviations (S.D.) (see the chart above). This is partly offset by the negative effect from our proprietary measure of Earnings Quality, at -0.6 S.D.

We use the P/E ratio that is based on the trailing 12-month index earnings, due to its statistical significance in predicting the incremental index movements as part of the model. The P/E ratio based on forward estimated earnings does not work as well, because analyst revisions add random variability to this measure.

The healthy trend in U.S. corporate earnings contributed to the below-average P/E ratio, and in turn, to its positive contribution to the model’s expected return of around 1 S.D. in the last two years. Most recently, profits increasing by 6.1% YoY in Q1-2012 (which was much higher than analysts’ estimates).

The P/E ratio rose slightly in June, to 13.8, driven by the rally in index of about 4%. It remains very attractive by historical standards, being well below the five-year average of 15.6. This explains why the P/E provides a significant positive contribution to the expected return as part of the PAR Model ™ (the green Contribution line on the graph above).

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