THE EXPECTATION RATIO REMAINS CONSTRUCTIVE DESPITE RECENT DECLINE

What a curious market we are confronted with.  It’s now quite clear that the rally is living on the liquidity based fuel from the Fed and the declining dollar.  In terms of valuations, the market appears fully valued if not overvalued.  It’s also quite clear, based on GDP, retail sales and the ISM data, that the economy is rebounding off the deep trough of Q1 2009 in what has to be one of the greatest mean reversions of all time.  From a technical perspective the market is in a robust uptrend.  Most importantly, we are in the midst of an expectations & earnings recovery.

So, while the rally appears to be ahead of the fundamentals, a confluence of positive momentum, upside data surprises and very negative earnings expectations continue to provide support to the market.   The sum of these sentiments and fundamental aspects have been most evident in our expectation ratio.  While the earnings rebound has been less than robust, expectations have lagged substantially.  I can’t recall a period where analysts were so wrong.  As you can see in the ratio (chart below), the steep upward slope is consistent with an environment in which expectations are misaligned with reality. This gives companies an almost unprecedented ability to under promise and over deliver.

Ever since our March 8th bottom call, I have maintained that the market could not be shorted.  This was almost entirely due to the surging expectation ratio.  Earnings and expectations drive stocks.  With a rebound in earnings and an analyst community that saw no such thing it was clear to us that you couldn’t bet against the earnings trend (regardless of how weak the real underlying fundamentals of the economy were and are).  With over 70% of companies outperforming analyst expectations it is practically impossible for the ratio to accelerate much higher.   The analysts simply can’t be more wrong (see below).  With that said, the current reading of 1.75 on the ER is still extremely high and represents an environment where analysts still have a great deal of ground to make up.  As we said many weeks ago when we sold into the current rally at S&P 1,100 we expected a substantial number of upgrades and price target increases to support the market.  This trend, though likely to improve as analysts increase expectations, is still firmly intact and continues to lead me to believe that the market cannot be shorted.

So where are we now?  My macro view is still that of the secular deleveraging bear market.  Much like Japan, we cannot create the foundation for a new secular bull without dealing with the underlying problem of debt.  On the bright side, we are 10 years into our bear market.  On the downside, we seem to be making all the same mistakes that Japan made as opposed to actually confronting and destroying those problems.   This creates further risk of a long and drawn out recovery as deleveraging continues to weigh on consumers and the government.

In terms of my micro outlook I continue to maintain the position that the fundamentals no longer support the v-shaped recovery that equities are pricing into the market.   I would not be shocked if the market rallied into year-end as investors chase performance, but the uncertainty regarding 2010 appears staggering in my opinion.  Like a chess player thinking many moves ahead, I believe investors are wise to get ahead of their opponents.   The smart money will begin focusing on 2010 soon and is likely to pare back risk as the uncertainties remain numerous.

As earnings officially end this week the fuel for the rally is coming to an end.  The endless upgrades and earnings beats are coming to an end and that means investors will begin to focus on the real economy again.  With the dollar near its lows and the market extended I think the potential for a counter-trend dollar rally and commodity decline adds substantial risk to the market in the near-term.   I will maintain my cautious and patient approach to this market until a more attractive opportunity presents itself.  Despite the underlying strength in earnings, the risks in this market remain substantial.