EXPECTATION RATIO REMAINS FIRMLY POSITIVE
The expectation ratio continues to forecast a stronger than expected rebound in corporate profits. The ratio, which compares sentiment readings with real earnings, signaled the sharp downturn in 2008, the turnaround in corporate profits in early 2009 and continues to forecast strong growth in profits compared to sentiment. The recent downturn in the ratio shows that the discrepancy between sentiment and corporate profits likely peaked last quarter when an astounding 75% of companies topped estimates. Despite this, the ratio remains firmly in positive territory.
2010 earnings will be characterized by an important transition from a margin story to a revenue story. We will be looking for the first signs of a rebound in top line growth this quarter. Although the economy remains extremely weak and we believe the secular bear market is still alive, we should begin to see single digit year over year growth in revenues in 2010. Profit margins have surged back to near record highs and should lay the foundation for firms to begin spending cash on hiring and expansions. As of now, estimates remain low enough that substantial revenue growth will continue to be overlooked, but as we enter the latter half of 2010 we will need to see substantial revenue growth to justify the surge in equity prices and to meet the expectations of the robust estimates.
TPC, I apologize for asking but for the longest time I didn’t realize this was your own metric. Can you explain again very briefly what is the import of the “Expectation Ratio” and whose expectation it is?
Many thanks.
Prescient,
It’s the summation of several of my internal indicators. This is one of those, “I could tell you but I’d have to kill you” situations. In all seriousness though, this indicator is the primary reason why I turned macro bearish in 2007/2008 and turned more bullish in early 2009. Wish I’d put more conviction in its readings early last year. Definitely worth monitoring.
TPC,
Seems like the consensus is for second half of the year to possibly see rate hikes and a pullback in equities. If the market is forward looking by about 6 months like some say, shouldn’t it start to price for it now instead of later?
That said, I have come to respect your ER. Thanks for sharing it. I wouldn’t be surprised with more beats as the estimates still need to catch up. How these analysts all manage to keep their jobs is beyond me.
I don’t see it that way. I have always been of the opinion that markets don’t discount more than a quarter in advance. For evidence of this just look at Alcoa. The stocks soars into earnings as investors discount great earnings and then the stocks get smacked on the actual report. How accurate is that for a discounting mechanism? Not very, in my opinion.
My more immediate concern is that we will see a “sell the news” earnings season. Regardless, corporate profits are turning north and should continue to outperform estimates for these next two quarters. Then things get a bit more dicey.
“My more immediate concern is that we will see a “sell the news” earnings season.”
ditto. i am going to look very closely to jpm’s release this week as well as the market’s reaction to it (i am overweight financials)
With the ER still forecasting earnings beats, isn’t it possible the market has already run up in anticipation of it, and now we get the sell on the news? If we get a pullback in the market during this earnings season, the market could be bought for next quarter earnings with ER still in bullish territory. Perhaps that’s when S&P will get to the 1250-1300 that some are forecasting later in the year.
TPC….
I like your ER ratio…thanks for sharing with readers. Your explanation makes it just that more worthwhile, so hope you continue to add your take with ER.
Thanks…
Looks like it has rolled over to me starting in Nov 09. Are you saying you would wait until it gets below 1x to go bearish. Not sure what sentiment indicators you are using but short interest, put/call, AAI bulls/bears are all wildly bullish. So far this season I havent seen much out of the companies that have already reported MOS, MON, AA.
That means analysts are still too bearish. The downtrend should not be ignored, but is no cause for concern unless it accelerates.
what should be a cause for concern is that AA is down over 10% now even with revenue far far ahead of analyst expectations. I assume the ER is forecasting similar earnings results elsewhere. But after a 70% run-up, we’re running out of suckers to take this thing higher simply based on beats. AA’s revenue didn’t even surpass the easy 2008 compares! I have no idea if that will be a common trend (weaker topline than 2008), but if so, what chance do we have of trending higher when the market itself is already 20% higher on a YOY comparison? As I’ve said before, you may be right about the short term direction being driven by this cat and mouse game. However, I fear you may be missing a major market top forming b/c you’re too focused on the same analysts that we all ridicule for being so utterly incompetent.
A “major market top” implies that there is some sort of catalyst coming that will result in a large downturn in the market.
What will that be?
Job openings (forward looking indicator) are back at the cycle’s low and continue to drop. We will see 11% unemployment very soon, much sooner than any one anticipates, even with all the massaging from the BLS to make things look better. How is that for a catalyst?
Very simple, Bill Miller alluded to it today on CNBC though he didn’t grasp the full implications (otherwise 2008 would have been kinder to him). This crisis is a completely different recession than anything we’ve experienced since the Great Depression. The point you made about AA’s balance sheet yesterday is one that can be made across a wide swath of banks, consumers, and other companies: their balance sheets are in terrible shape and it will take many years to fix the wreckage left behind from the housing bubble. It took Japan 15 years in the midst of a global boom and with a large export economy to fall back on before their balance sheet damage was repaired.
Right now we are priced for a strong recovery b/c the market still thinks this is a regular ol’ recovery like we’ve seen in the post depression era. As reality sets in that this time truly is different (though not the way they envision it), that the economy is still anemic despite the best efforts of the Fed, valuations have only one way to go, despite what the knucklehead analyst community thinks in the short-term. We have not turned the corner on jobs, we have not turned the corner on housing, we can only guess the impact that the Fed’s ending of MBS purchases will have in March on mortgage rates. Oh, and the dollar has bottomed. None of these key fundamental points are favorable to this rally.
We’ve already seen some of these grenades go off and just b/c investors are complacent now doesn’t mean that will continue for six more months or even a few more weeks. I’ll leave you with this little nugget from Koo that succinctly summarizes our risks:
“US mortgage loans in 40/50 states, and all of the biggest states, are nonrecourse, which means that borrowers can simply return the key to the bank and walk away. At the moment nearly 35M houses may be worth less than their owners paid for them…To put this number in perspective, there were only 2M subprime mortgages, and problems in some of them nearly destroyed half the US banking system. The US would face an unprecedented crisis if 35M homeowners [or a portion thereof] decided to return their keys and walk away.”
Though not ideal, I haven’t minded being wrong for the last five months of this move. B/c the last thing I wanna do is be long when the lights go out at this party.
mortgages are not nonrecourse in NY
The mistake all you bears are making is that we are going to fall off a cliff again. The government is not going to let that happen. Why fight it?
Dan,
Did the govt allow it to happen in 2008, just to punk us? Did the Japanese govt allow this problem to inflict great pain on their economy for a 15 year period? Or maybe the govt is actually a lot less powerful at solving these balance sheet issues than Mr. Market thinks.
And before anyone gives me the QE schpeal on why this time is different, keep in mind Japan’s experience, from Koo again:
“The central banks implementation of QE at a time of zero interest rates is similar to a shopkeeper who, unable to sell more than 100 apples a day at $100 each, tries stocking his shelves with 1,000 apples, and when that doesn’t work, adds another 1,000 apples. As long as the price remains the same, there is no reason consumer behavior should change. This is essentially the story of QE, which not only failed to bring about economic recovery, but also failed to stop asset prices from falling well into 2003.”
Maybe our politicians are smarter and savvier than their politicians so perhaps this time truly is different. If you’re long, you sure better hope so..
VCC,
I don’t deny that we are making things worse in the long-run, but in the short-term nothing has changed. The government is still propping up the markets. Until that changes I don’t see how the market will fall substantially.
We are not Japan either. As Koo says, we will continue with our stimulus until it’s clear that the delevering is over. We will not make the same mistakes Japan made by stopping and starting the stimulus.
Bet against it if you must. You’re just one more short that will be run over by the freight train.
Dan,
How exactly are we not Japan? Huge asset bubble rise and sudden fall? Check. Massive exposure left behind by banks and property owners? Check. Zombie corporations (in Japan) / Zombie consumers (in US) / Zombie banks all the way around? Check. Deflation? Check. Applied stimulus? Check. Printed a massive amount of money? Check. 80% peak to trough drop in the equity market? That’s only happened in Japan thus far. Take a look at the Nikkei from 1985-2009 for some perspective on the effects of a debilitating deflationary spiral. But you’re right, we’re probably better and different in some undefined way, most likely b/c of our govt brain trust.
You may also want to brush up on how Soros made his money. The idea that prices change our perspective of the underlying fundamentals, that idea is the only way I can see a justification for this rally continuing like “the govt won’t allow us to go back down.” By definition, bubbles arise unexpectedly. It sure wouldn’t be a “major market top” and epic bubble if you saw it coming now, would it?
If you stay long over the next six months, one of us is sure to get hit by an unexpected freight train. I assure you it won’t be me.
If you read Koo you should know that he believes the US is doing the right thing by stimulating the economy.
In one sentence you say Koo is right, now you’re saying he is wrong? We are not Japan because we are implementing the plan that Koo himself said Japan made the mistake of NOT implementing – continued stimulus.
Care to argue that one?
No problem, I’ve taken great pains to understand Koo’s main points. I wouldn’t be much of a macro speculator if I dismissed “The Holy Grail of Macro Economics”. Koo argues for continued FISCAL stimulus so long as the private sector is deleveraging. The mistake that you and all the other bulls are making is thinking that this deleveraging is complete or near completion. It took Japan the better part of 15 years, this during a booming global macro period. Do we have the guts to apply fiscal stimulus for a long enough time period to allow CitiGroup to go from insolvent to solvent? I’m guessing no, not when we’re already talking about lifting stimulus in year 3 of the crisis.
But the reason I remain bearish today, aside from deteriorating technicals that once mattered like volume, is b/c Mr. Market hasn’t even figured all this out yet. Mr. Market is focused on money printing as the Holy Grail of Macro Economics. Can you explain to me why Japan’s interest rates are now entering a third decade of being near 0%? Isn’t that the foundation upon which your long position rests upon, that QE is/was the magic bullet?
When you talk about Koo and stimulus, remember that he is only talking about fiscal stimulus. His exact word for describing QE during a balance sheet recession? Impotent. In other words, your long position, especially if you continue to hold for another six months, rests upon a policy widely celebrated yet one that the premier expert on balance sheet recessions finds useless given Japan’s experience.
I’ll also offer a prediction that’s so crazy you’ll probably think I’m out of my mind. When you ring in New Years 2020, the fed interest rate will still be at or near 0%. Take that one to the bank.
Look at the companies that have reported, even RIMM after the initial pop is rolling over, that was a gift to short north of 70. If you would have waited for the ER to move above 1 you would have missed the biggest leg up the upswing from march-june. In March everyone was expecting the companies to miss estimates so when they beat everything took off. This time everyone expects companies to all top estimates so the upside is not there. RIMM is the prime example, it blew out numbers only to be trading back where it was 30 days ago. In addition when the FED embarked on QE you had $40 Oil, now north of $80 the fed has to tighten the reins or risk another oil shock. All in all, the risks appear to significantly outweigh the rewards at these levels.
I agree. TPC, are you misreading your indicator? It looks like the trend is more important than the actual level. It looks like we topped last quarter. Am I wrong?
We’re really jumping to conclusions based on the AA report….Let’s wait and see what happens. I’d be willing to bet that 60%+ companies beat earnings and the market is higher or unchanged from here in a month.
That’s what my research says anyhow.
As for the ER, yes, the trend is important. It’s a leading indicator not a coincident indicator. I mentioned this back in January 09 when I made my 09 investment predictions and I said long-term investors should add to positions. http://pragcap.com/light-at-the-end-of-the-tunnel
For now, the near-term trend is down, but I still believe the current earnings season will be better than investors believe.
Why do you keep your indicator private? Sharing the info can probably help you fine-tune it. When you hoard information, your doing a disservice to yourself, keeping you from finding looking for new things. If you give everything away, you are free to look for more.
It’s been thoroughly backtested. It’s rewarding having a very open and public website, but some portion of the house recipe needs to remain a secret….
Does the decrease in the ER point to earnings being much muddier, meaning more will miss than previous quarters? I mean, to be honest, it usually matters on what the guidance is. But in March/April companies missed and the markets rallied regardless. Things seem to be getting more and more difficult.
You are all missing the more important point here….
Look at the balance sheet of the United States of America. If you were looking at a company with a similar balance sheet (and similar off-balance sheet liabilities, which are huge btw) would you invest in that business?
Easy answer. NO
TPC,
I would be interested to hear, if you are willing to publish it, the results of the backtesting of your prop model?
Similarly, again if you are willing, would you or could you publish performance stats for the portfolio you run as a result of all your work?
This is my first post but i’ve been a reader for about 4 months – great website, thanks.
For what it’s worth (which is not much in my opinion since it’s unverifiable):
06: 42%
07: 26%
08: 19%
09: 7%
That’s with a Sortino ratio of 2.1 and max drawdown of 12%. Clearly, I remained far too bearish in 2009, but that’s on the back of my greatest investing achievement ever – a total outperformance of 60%+ in 2008.
Of course, I do not run a global macro only portfolio (as you might assume from reading TPC). My specialty is not even what I primarily discuss here so it’s difficult to gauge whether my analysis here would actually lead to good performance in a global macro portfolio.
finaly a good back and forth debate, good to here market savy views. judging this market of stocks, it does not look or feel too good as far as buying here, unless you’re buying protection…how can one be bullish at this point being realistic about the macro of the US economy, the upgrades left and right, the language of the media, specially the new line- “would you buy it” ? yes I would, sayd that two year old wet behind the ear when she asked about AA, this is a joke, that clwon and his tsunamis…never heard him pick a buy low or sell high for us, and if you trade heavy and listen to the guys down by the S&P pit, you hear them laughing for the past two months, all those chrts, bands, 50 200 day averages, throw them away, they’re about to kill you, they will always make you buy tops and short bottoms, specially now at this point most charts(line) are poining to the stars, how meny realy understand candle stick(charts), don’t even want to go over all them numbers that keep on coming out from all kinds of back offices telling us its all good (m in good mood)…was a bull as it gets 11/08 on financials and commodities, 02,03/09 on everything else, had to wear ear plugs to not hear all them clowns advising sell, the world is over, EWZ, FXI, EWJ, RSX, EEM, and now the exact opposite, buy them now, come on, lol, have less then 10% left to sell, never thought we’ll get so high so quick, what got better on main street’s economy ? is small business getting better ? are they expanding-hiring ? too scared to ask if king dollar’s about to get de-valued, I know wall street have nothing to do with main street, but not this time I don’t think, looks like the fun’s about to begin, I would totally oil up my keyboard’s sell keys just in case, good luck to all, be careful…