The expectation ratio has surged to a new two year high in what is an obvious sign of corporate earnings strength. Of course, as we all know by now, there is a distinct difference between strong underlying fundamentals and low expectations. This surge in the ER represents more the latter. Analysts have been miserably slow to catch-up to the pace of bottom line growth. As we have detailed here over the course of the last few earnings seasons, margins are expanding at a pace not seen in 25 years as cost cutting far outpaces top line deterioration.
For our purposes, the ER has largely lost its predictive usefulness since we turned bearish last week at the market highs, but we will continue to track it closely as the rally morphs. In all likelihood, we will see the ratio deteriorate from here as it is difficult to imagine that the analyst community will remain so far behind the curve. As expectations catch-up to reality we would expect the ratio to narrow substantially and stock gains to become more difficult going forward.
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.