Here's one of the biggest misunderstandings on Wall Street: Most analysts are emotionalists more than analysts. In other words, analysts are driven by emotions and crowd behavior more than by cold facts - and I have charts to prove it (this article is slightly longer than average, but the charts will be well worth your time).
Barron's just published its spring Big Money poll, a survey of heavy hitting money managers. The title of the article is: "Reason To Cheer" (which goes along nicely with a front cover screaming: "Outlook: Mostly Sunny").
There are many reasons money managers expect higher prices, but earnings is probably the biggest common denominator. Here's what Big Money says about earnings:
"People don't appreciate the gains that good companies have made"
"It's time to reap the benefits of accumulated earnings growth"
The Corporate Earnings Boomerang
Corporate earnings can easily turn into an indicator boomerang as a reversion to the mean is inevitable.
The chart below plots the S&P since 1998 against 12-month reported earnings (datasource: as reported earnings by Standard & Poor's). We see that the 2000 and 2007 highs were both preceded by all-time earning highs.
>> click here to view larger chart
Now again we've reached an all-time high in corporate earnings (we'll put that record high in context in a moment). Along with that, earnings estimates going into 2013 are off the charts (12-month earnings expected to be $107).
It's not shown on the chart, but 2008 estimates for 2009 earnings were at least $113 (as of April 2008). Actual 2009 earnings were in the single digits for much of the year. Clearly an estimate is only worth as much as the paper it's written on and record high earnings are more negative than long-term bullish.
Barron's and Analysts' Track Record
This wasn't the first Barron's Big Money poll, so let's take a look at what previous spring polls showed:
April 2010 Money Poll: "The bull ratio on cash is the lowest on record."
That was bad timing to discard cash and the polar opposite of what the April 16, ETF Profit Strategy Newsletter warned: "A minority of equity positions are equipped with a put safety net (referring to the put/call ratio). Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling, results in more selling. This negative feedback loop usually results in rapidly falling prices."
Just a couple of weeks later Wall Street got hit by the Flash Crash and a 17% decline.
April 2011 Money Poll: "The Big Money bulls see the Dow Jones (DJI:^DJI - News) climbing to 13,066 and the S&P 500 (SNP:^GSPC - News) reaching 1,412 by December. The Nasdaq Composite (Nasdaq:^IXIC - News) calls for a rally to 3,048."
The April 2011 ETF Profit Strategy Newsletter on the other hand warned: "A major market top is forming. 1,369 - 1,382 is a strong candidate for a reversal." Over the subsequent months the S&P fell 20% (as low as 1,075 - 31% below analysts' 1,412 target).
After a 20% drop Wall Street was ready to declare a bear market as those October 3, 2011 headlines show:
"S&P falls to the bears" - TheStreet.com
"S&P enters bear market territory" - Reuters
"Think the economy is bad? You haven't seen anything yet" - CNBC
Just one day earlier, on October 2, 2011, the ETF Profit Strategy Newsletter predicted a 20%+ rally and recommended to: "Exit short positions around 1,090 and buy (long positions) after the S&P (NYSEArca:SPY - News) registers a new low (around or below 1,088) and comes back up above resistance at 1,088."
How Insane Are Record Earnings?
There's a lot of talk about economic improvement and no doubt compared to 2008/09 there have been improvements, but that's faulty reasoning.
When Michael Jordan broke a bone in his foot in 1985 his goal was to get back to playing his best compared to when he was healthy, not compared to when he had a broken foot.
Keeping this in mind, how does the economy now compare to its 2007 highs, not the 2009 lows?
- Unemployment today is still 86% higher than it was in 2007
- U.S. debt (based on outstanding Treasury debt) is 81% higher than in 2007
- The government had to retire NASA space shuttles because it's too broke to fund NASA
- 46 million Americans are on food stamps (up 170% since 2000)
Greece's default nearly tore apart the European Union. Its problems started unassuming in the beginning but turned into the biggest sovereign default in history.
Spain is next, and Spain's economy is 4.6x bigger than Greece's. Italy's economy (another fiscally lackadaisical case) is 50% bigger than Spain. Spain and Italy's combined economies are 11x bigger than Greece's.
- Earnings are at an all-time high
- On April 2, 2012 the Dow was only 6.3% from its all-time high
The chart below shows what the Federal Reserve, European Central Bank and other central banks can and cannot do. It also provides a sober visual of just how perverted the stock market's performance is in context with various economic indicators (click here for a larger version of the chart).
>> click here to view larger chart
Yes, central banks can prop up stock prices and stabilize bond market yields, but they can't heal a sick economy.
How do central banks stabilize bond yields? Let's recap (using Spain as example):
Spanish banks are in trouble because they own Greek and Spanish bonds. To help ailing banks, the ECB provided euro1 trillion of 1% loans (LTRO I and LTRO II), which the banks used (and they are encouraged to do so by the ECB) to buy more Spanish bonds.
Spain is suffering from the financial flu and instead of quarantining the virus the ECB is spreading Spain's debt across Europe. Europe's approach is more like "a problem shared is a problem halved." but a virus shared is an epidemic encouraged.
The Moral of the Story
The world's central banks (in particular the Fed and ECB) have bid up stock prices to near their all-time highs. Even without sovereign debt defaults stocks tumbled 50%+ from their 2007 highs. How low can stocks go if more euro countries go belly up?
The bottom line is that the down side potential is now larger than at any other time since the Great Depression.
As grim as the long-term outlook is, it needs to be balanced with the generally positive bias of Presidential election years and of course the Fed's printing press.
I use important support/resistance lines to separate immense down side risk from liquidity induced upside potential (see above-mentioned April 2010, April 2011, and October 2011 scenarios). It's a fact that no rally starts without a break out above resistance and no meltdown starts without a break down below support.
The ETF Profit Strategy Newsletter identifies the key support level that needs to hold to prevent stocks from dropping like a rock and the key resistance level that - once broken - would foreshadow higher prices.
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