Wall Street Out of Synch With Reality

While the S&P 500 has rebounded 13% off its low on Feb. 11, the earnings picture at major U.S. companies continues to worsen. Earnings estimates have steadily fallen all year for all major industries except insurance, according to an analysis by TIS Group.

Looking at earnings year-over-year in order to analyze similar time periods, the TIS analysts note that the trend in reported earnings has been in a steady downtrend for two years. Of the companies that have reported their results for the fourth quarter of last year, earnings have been down 4.5% on average year-over-year.

This is not necessarily new news, but the rate at which this is happening is accelerating. Professional S&P 500 forecasters at brokerages, however, continue to remain very optimistic. In short, the optimism seen by Wall Street is out of synch with the worsening results at companies. These kinds of divergences are typically reconciled before long in the direction of the fundamentals.

This comes at a key juncture because stocks are currently very stretched. Jason Goepfert at Sundial Capital points out that every stock in the Dow Jones Industrial Average is now over its 10, 20 and 50-day moving average. This has only happened one other time in 25 years, he says. Prior signals tended to be short-term neutral, but long-term positive.

Dating back to 1990, the only other date where all members of the index were above all three short- to medium-term averages was Oct. 27, 2011, Goepfert reports. After a brief pullback that worked off overbought conditions, the DJIA powered higher in the months following.

To investigate further, Goepfert went back to 1990 and looked for any time at least 90% of the Dow’s components were above all three moving averages to see how the index performed going forward. Sometimes what we see when looking at shorter-term moving averages is that extreme overbought readings occur during bear markets, because volatility tends to be higher and the short-term rallies can be impressive. But he doesn’t see that in this data.

When looking at shorter-term moving averages, extreme overbought readings occur during bear markets.

Granted, there were only two bear markets during the study period, but by including a medium-term average like the 50-day, there were limited occurrences during the two bear markets, at least not until they were ending. The only real failure among the occurrences was in October 2007. That one coincided with a blow-off move to new highs and the Dow formed its bull-market high a few days later, Goepfert observes.

There were only four occurrences when the DJIA had been at a six-month low at some point in the past three months as it was this time: 12/04/1990, 12/31/1991, 11/06/1998 and 10/27/2011. While shorter-term returns were nothing special, the Sundial data shows that the DJIA did well over the next three to 12 months.

Bottom line: We’re probably seeing overbought conditions that normally lead to subpar returns in the next two to four weeks. But unless it leads to a blow-off speculative peak like October 2007, it should be considered a sign of intense buying interest from lows that should lead to materially higher prices in the long term, Goepfert concludes.

Best wishes,

Jon Markman

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