Our proprietary expectation ratio continues to decline despite remaining at rather robust levels. The ratio measures a number of different financial statement indicators and compares them to current and future expectations. Thus, the ratio is not simply a backward or forward looking indicator, but an intuitive and predictive indicator. By comparing actual income statement performance to expectations we are able to gauge where stock prices might head based not on the underlying strength of income statements, but the strength of those income statement compared to expectations. After all, as we’ve seen over the course of the last 6 months it doesn’t take robust organic earnings growth to drive prices higher. It simply takes very depressed expectations and an improvement in the level of deterioration. Stocks move based on reality compared to expectations – not just reality.
As we predicted in mid-October with the S&P at 1,100, the expectation ratio was likely to peak as analyst’s expectations couldn’t possibly be much farther from the earnings reality. We said analysts upgrades and price target increases would likely keep a floor under the market and like clockwork we’ve seen dozens of upgrades every day as analysts play catch-up and boost their earnings estimates. This is reflected in the declining expectation ratio which is now forecasting more strong earnings, but at a lesser rate compared to expectations. The latest reading of 1.31 shows that income statements remain robust compared to analyst expectations. This is likely to support the market heading into the next earnings season, but gains are likely to become more and more difficult. I very much agree with Teun Draaisma at Morgan Stanley who believes the earnings picture will get substantially more challenging in 2010 and likely lead to sub-par equity growth. For now, however, short positions remain risky propositions in our opinion. In fact, I would look to implement tactical long positions in the beginning of January as earnings begin to roll out in the latter half of January. Investors are certain to bid up prices into and during the upcoming earnings season, which, based on my early analysis, will likely be very similar to the previous 3.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.