September 24, 2012 A magic number? Foreign markets were lower partly due to a story in a German publication that Greece’s budget shortfall is considerably more than previously assumed. Greek officials later denied the story, but their denial had little influence on futures that had a negative pre‐opening bias. A drop in the German business sentiment index also was a modest negtive. Lennar (LEN), a major U.S. homebuilder, topped earnings expectations by a wide margin when it reported earnings this morning. Apple (AAPL) was lower after reporting weekend iPhone 5 sales that at five million actually were less than expected. Lack of supply, however, was blamed for the shortfall, not lack of demand for the phone. The stock was down as much as 17 points soon after the opening, but it cut this loss roughly in half 40 minutes into the trading session. Facebook (FB) was the subject of the cover story in Barron’s this weekend with the suggestion that the stock is worth only $15 a share. The stock was down nearly seven percent early today at $21.34. Although it probably was not a major factor, there was talk of a revised sequestration plan that might be proposed in order to force an earlier move by Congress to address the fiscal cliff issues as well as longer‐term tax questions. The problem apparently is that neither party knows how to get the process started due to the nearness of the presidential election. The market opened lower but pared the early losses. Seventy minutes into the trading session the Dow was down 32 points, and market breadth was 5‐4 negative. This week, end of the quarter institutional window dressing should be part of the week’s activity, which could provide the market an underlying bid. There have been numerous articles written about the underperformance this year by many hedge funds. There could be a drive on their part to become more aggressive in an attempt to narrow the performance gap. At the end of a quarter, however, attempts to show more fully invested positions could prompt many funds to be buyers in advance of their quarterly reports. Interestingly, however, the Wall Street Journal today carried a story that suggested some managers might choose to sit out the last quarter in hope that the market drops to narrow the gap. In prior reports we have mentioned that at some point market valuation could become an issue. Standard & Poor’s does not think this is a problem yet. In a recent report, S&P dusted off an old but probably still valid way to assess market valuation. S&P explained what is called “The Rule of 20” by noting that the S&P 500 is fairly valued if its P/E on trailing 12‐month GAAP (as reported) EPS plus the rate of inflation equals 20. Any number above 20 points to an overvalued market, and any number below indicates undervaluation. The rolling quarterly “Rule of 20” value (P/E plus CPI) was a median 19.8 since 1948, and the actual versus implied value for the S&P 500 recorded a median differential of only 1.0%. Despite a few wide variations around 20, it has been fairly consistent, as nearly 70% of all observations since 1948 saw the sum of the S&P 500 P/E and inflation trade between 15 and 25. S&P pointed out that as of last Friday, the S&P 500 closed at 1460.26. The P/E on trailing 12‐month GAAP earnings was 16.61 (the P/E falls to 16.48 if you include the third quarter estimate). The August headline CPI was 1.93%. The P/E plus inflation equaled 18.54, implying that the market is currently undervalued by nearly 8%, and that the fair value for the S&P 500 is 1575. The 1575 level of the S&P 500 in S&P’s view is in line with its technical objective for the S&P 500 and fundamental objectives some Wall Street market strategists feel is possible. The S&P report also noted that historically once the S&P 500 has recovered all that it lost in the 54 declines of 5%‐10% since WWII, the S&P 500 advanced an additional 8% within three months before succumbing to another decline of 5% or more. Obviously there is no assurance that the market will act as the Rule of 20 suggests it could. The calculation of the Rule, of course, includes two key variables, the accuracy of which might be debatable. The key variable is the earnings component. With third quarter earnings expected potentially to be lower than third quarter earnings, which might prompt earnings expectations for the fourth quarter to come down,the P/E ratio of the market could rise and threaten to take the Rule calculation above 20. The fact, however, that the Rule previously has produced a number greater than 20 and not immediately resulted in the market turning lower does not suggest exiting stocks even if the P/E ratio shoves the Rule number above 20. With the market focused on the very low likelihood that the Fed will change its policy stance anytime soon as well as little expectation that the CPI short‐term will rise sharply, The Rule is not likely to lead to a level above 20 in the months immediately ahead. In addition to some housing data due this week, reports on the Gross Domestic Product, the Chicago Purchasing Managers Index and the Michigan Sentiment Index could be influential. We suspect, however, that end of the quarter activity could be this week’s dominant force. Any news from the European Union, of course, will not go unnoticed. Have a great start to the week. The scope of The Market View Daily is generally limited to commentary regarding economic, political or market conditions and certain of the previous day’s events; but such commentary does not recommend or rate individual securities. 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