My expectation ratio is one of my preferred stock market indicators. In essence, it is made up of several earnings related components and compared to analysts expectations. This makes it an intuitive and forward looking indicator. It is a good way of gauging Wall Street expectations vs reality in earnings. When earnings began to deteriorate in 2007 the ratio became negative for the first time in many years – which was right around the time where I became very cautious on the markets. You could literally see the dominoes falling one by one. I remember the housing stock’s earnings crumbling, then consumer discretionary began to get weak, then financials and on down the line.
The indicator has only just recently become positive again which is telling me that analysts are finally beginning to cut their estimates to realistic levels. The indicator was a little early to the party in 2007 and I presume it will be early again in forecasting a recovery, however, it is a good sign that now is a time when you might want to be dipping your toe in the waters. If you’re young and have a long time horizon you certainly want to be adding to positions.
The Expectation Ratio is only useful if we see a sustained strengthening in earnings later in the year. If earnings continue to deteriorate we will need an equal deterioration in analysts expectations or prices will likely decline substantially. Eventually we have to see real recovery in corporate profits for the market to put together any sort of sustainable run. As of now we’re either late in the earnings cycle or at the very very early stages of a new one.
As I have said before, in order for any sustainable rally to ensue, we need one of two things to occur: earnings need to begin to improve or expectations have to get SO negative that companies outperform. Either way, this is a positive development. Nothing is more important than market psychology and this is one of the first true signs that psychology has become decisively negative.
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.