The economic recovery is becoming broadly accepted and potentially priced into the markets.  The recent string of upside surprises in earnings reports and economic data show that the investment community has largely unappreciated the strength of the recovery.  But as the analyst community raises the bar the expectations for continued growth will become increasingly difficult to overcome.

While the days of 60+ ISM readings, record margins, and persistent earnings beats seem to have become the norm, the truth is that many of these indicators are highly cyclical by nature and/or mean reverting.  It’s not unusual for the investment cycle to peak at a time when expectations are high and this cyclicality begins to bite.

Recent data shows a few signs of at least a near-term blow-off in expectations.  This doesn’t mean the bull market is necessarily over, but it does present a sizable challenge for markets going forward.  Remember, market direction is not just the sum of the opinions of its participants.  Market direction is the sum of those opinions when compared to expectations.  The market does not care whether you think the FOMC will raise rates today.  You could very well end up being right and the market could still move against you as the opinions of the other participants are already priced into shares and broadly expected in advance.

There are several indicators that compare reality to expectations and give a real-time perception of this phenomenon.  I highlighted the Citi Economic Surprise Index last month.  This index shows the weighted historical standard deviations of data surprises comprised by the analyst community compared to the Bloomberg median estimates.  It has been flashing a warning sign for several weeks now and although it has come off its highs the index remains at a historically elevated level.

A few weeks ago Barry Ritholtz highlighted a similar phenomenon noted by SocGen analysts:

“After undergoing a massive rally since last September, risky assets are now technically vulnerable: SG Quant sentiment indicator is close to an all-time high, economic revisions have rarely such a high percentage of upgrades, equity volatility is at a four-year low, the Canadian dollar is dear versus the USD and lastly inflows into equities reached $8bn last month, led by “panic-buying.””

My Expectation Ratio, which measures the strength of future earnings growth compared to analyst expectations turned negative (sub 1.0) on February 28th.  This is the first time the index has turned negative since March 12th of 2010.  This is generally consistent with an environment in which strong earnings and robust corporate balance sheets are broadly expected and priced into shares.  While the current reading of 0.97 is by no means an extreme negative it could prove to be a risk in the current earnings season if we see further deterioration.  Over the course of the majority of the rally from the 666 lows the ER has remained firmly in positive (1+) territory except for a brief period preceding the flash crash.  A sustained downtrend in the index would likely precede a far more challenging earnings environment.

None of this points to impending doom and gloom in the markets, but as expectations rise in the near-term these indicators create barriers that the market could have difficulty overcoming.  The recent oil scare and the crisis in Japan could be enough to temper sentiment and bring expectations back down to earth.  That process, however, could take some time and involve continued downside risk in equities as these high expectations are cleared and fear breeds opportunity for upside.


Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • boatman

    meltdown in japan,god forbid, brings down this house of cards…..somethings going to do it…i hope its not that.

    related news $700 tril to change earth temp one degree:

  • boatman

    realtime gieger counter in japan per greg merrill (

  • B Ferro

    None of this is reflected in the 2.5% mutual fund cash assets ratio…

    Everybody is so wedded to this being a new secular bull and a sustainable recovery now, will be interesting to see if/how buy-siders look to justify their current enthusiasm moving forward.

  • first

    Excellent timing, do you have a Cristal ball?

  • Andrew

    American companies can continue to make money, but it all turns out badly as American consumers HAVE NO MONEY.

    Inflation, if it carried over to wages would be, the saving grace, as it would lessen their debt burdens. The government, with the central bank, could make this happen by printing checks for say, $5000, for every person over 18 in the country – and it could do it without issuing debt. We get inflation, and people have money to pay down their debt.

  • Witt

    Cullen, do you publish your ER on the site? If so, I can’t find it. I’m trying to build a model right now, and I think that would be a golden indicator. If not, would you mind sharing exactly how you’ve calculated it?

    And thanks for all the hard work, this has become my favorite discussion forum for the current state of the economy. However, being an UBER BEAR, I thought I might propose a new topic. Could you help us and lead a conversation about amending the current monetary system?

    Unlike myself, it seems you’re optimistic enough to believe the system won’t flat out ‘break’ (for lack of a better word), but I think most of us agree that this monetary system isn’t going to work in its current form in the future. This isn’t the kind of monetary system I want my future children to grow up around, and I think it’s time we get serious about how we change it before congress panics and passes another 1k page bill in a week’s time where no one knew what the hell they were doing.

    I understand there is a small audience that actually understands monetary policy, but a peoples discussion in advance may have some influence this time around – people will want to get involved when the system breaks… again. As the old proverb goes: fool me once, shame on you; fool me twice, shame on me. It happened in the depression, and we restored order to finance for a long time.

    Maybe I’m naive, but I think with the means to alternative framework and views towards monetary policy, I believe that people will educate themselves this time around. But until there’s an alternative framework, the big banks and business’ views on the matter will remain dogmatic. Though I don’t think they’re wholly wrong, and without the current monetary system we may have never known the quality of life we have enjoyed over the past several decades, there are glaring flaws in their positions that have only fostered the growth of systemic risk. (And I know you’ve been working towards this for some time, but I think it needs to be put into high gear).

    Right now, it feels like a game of prisoner’s dilemma. If the banks collude, and don’t call in their margins, a sell off can be avoided. At least for some time. I think that’s what’s going on as we watch the US drop less than much of the rest of the world, but at some point panic will take hold. Prisoners invariably rat each other out (or in this case sell first). And as these drops and defaults eat into the repo market, margins are going to have to be met. A few defaults and we’re done. (if US CDSs really carry a notional value of $600T, and 5% of that defaults and they buy back the contracts at a negligible 5% of interest, there goes another $150B that has to be covered by an ensuing fire-sale bringing about more of the same.)

    What’s interesting though is that with the conglomeration of financial companies, when the defaults start, almost invariably the big ibanks will end up owning the assets of mortgages and businesses on mainstreat. I.E. they own the majority of the only remaining real value – the means to hard assets and production. Most people don’t seem to see this, but because the banks own the insurance companies and savings banks, everything goes all the way up the line when they start calling in their debts. (and maybe I’m wrong, and I’d love for someone to explain to me why… seriously it would put my mind at ease.) But if this is the case, the banks own something better than money when this is said and done – ownership. And that’s simply not right. It’s fair that there’s a tax to access capital – that’s the service banks provide. But that doesn’t mean they have the right to screw up the system and then consolidate it’s power by taking it from the american people.

    Perhaps Thomas Jefferson said it best almost 200 years ago: “I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property – until their children wake-up homeless on the continent their fathers conquered.”


  • Cullen Roche


    Thanks for the comment. I don’t publish specifics on the ER. Sorry.

    What would you suggest I do about creating a forum for that discussion? I could create a new discussion in the forum?

  • Greedsgood

    Cullen – I’d appreciate your thoughts on this iShares Japan ETF (EWJ) discrepancy versus the overnight 10.5% drop in the Nikkei. The flat close on the EWJ would imply that we should see an 8% pop at the open in Tokyo tonight. A bounce is one thing but….

    From the action during the last hour just hanging around the flat line (like someone had orders to buy until flat) seems suspicious. I cannot reconcile the implied Nikkei move with the lack of any meaningfully positive news. Add significantly lower markets across the world today, including the US indices and I am absolutely puzzled… Your thoughts?;range=1d;indicator=sma;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

  • Cullen Roche

    Nikkei futures traded back up to about 9K today so the loss is only ~4.5%. I am not really familiar with the breakdown of the EWJ, but it is not the Nikkei. I am just looking at the top holdings of the fund (TM, HMC, etc) and they rallied back enormously today in the USA. The fund reflects that….So, this fund has a disprportionate allocation to companies that rebounded today.

  • Greedsgood

    Thanks, an excellent analysis of some key points I overlooked.

  • Cullen Roche

    Glad to help.

  • Greedsgood

    One final follow up to my query – Nikkei 225 futures opened down slightly and are now down about 2%. Not exactly what I would expect to see after the strong performance in the EWJ (understanding that the weightings and holdings are not identical)

  • billw

    All of this analysis of “the market” is good, but until we actually have a market that is not rigged by daily infusions of Fed money we have no idea of where the market stands on any issue.

  • Witt

    I think a discussion forum would be a great idea. I’d certainly love to participate going forward.