Breakout

One Small Indicator Having a Big Negative Impact on Stocks

Breakout

After languishing for almost a month, stocks have burst back to record highs as investors continue to prefer the upside opportunity that only the stock market has been able to provide for the past several years.

And yet, the stampede of money behind the move could actually be buying into something that isn't, and may well never be.

"Over the last year, virtually all of the market's gains came from multiple expansion," says Vadim Zlotnikov, chief market strategist at AllianceBernstein. "And the reason the multiples have expanded is because the perception of risk has declined. The second the perception of risk went up, the market went down."

Put another way, investors have been willing to pay more and more for each and every dollar of corporate profits. The problem with this "anticipation of better fundamentals," as Zlotnikov calls it, is that right now there's really no pot of gold waiting at the end of the rainbow, so to speak, to make it all worth while.

"We are seeing some good signs, like manufacturing indexes improving," he concedes. "But as of today, we have yet to see a dramatic improvement in earnings that would be necessary to fuel to fundamentals."

In fact he says, before that fundamental improvement is going to happen, "the one economic indicator that's still depressed" is going to need to rebound. Specifically, Zlotnikov says the next leg-up for stocks won't happen until "small business confidence and hiring pick up significantly", given that this critical slice of the economy accounts for a third of the country's jobs.

As it stands now, corporate sales and profit growth have all but stalled. With about 20% of the S&P 500 having reported third quarter earnings so far, FactSet analyst John Butters has flagged the early weakness of the results and writes: "In aggregate, companies are reporting earnings that are 2.3% below expectations. Over the last four quarters on average, actual earnings have surpassed estimates by 3.7%. Over the past four years on average, actual earnings have surpassed estimates by 6.5%."

Mind you, these so-called negative surprises are coming in below estimates that had already been cut in half in the past three months.

As much as Zlotnikov thinks "the most likely direction is up" for the stock market over the short to intermediate term, it is not going to be without worry.

"The problem is a lot of the gains from multiple expansion are behind us. So you really do need to have fundamentals come in," he says, referring to the present economic environment as "not a disaster but very lackluster."

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