THE BIGGEST RISK TO THE MARKET IS WALL STREET ITSELF

THE BIGGEST RISK TO THE MARKET IS WALL STREET ITSELF

Courtesy of The Pragmatic Capitalist 

The single largest hurdle for the market at this juncture could very well be Wall Street itself – more specifically Wall Street’s analysts. The average analyst thinks the S&P 500 will rally more than 13% from here until the end of the year (see here). Most analysts are looking for 2.5%-3.5% GDP growth this quarter – David Rosenberg says that is FAR too optimistic.  Ironically, JP Morgan’s analysts have devised an index that measures economic results against consensus estimates (figure 1). In recent months the index has taken a decisive turn for the worse:

“Weak US economic data continue to weigh on equities, preventing them from breaking out of their three-month range. The weakness can be seen in our US Economic Activity Surprise Index (top chart). The EASI dipped to a low of -37 in mid-July, a level last seen in the months after the Lehman bankruptcy. Despite some improvement over the past few weeks, at -20 the EASI remains very negative by historical standards. The EASI will likely need to turn positive again for equities to break out of their range.”

(figure 1)

The cyclical nature of market psychology is easily proven, but harder to visualize. Figure 2 displays the psychology of a bubble and this cyclical and mean reverting phenomenon. I like to think of the market as one huge trending system.  Extreme disequilibrium occurs only when the system becomes unusually positioned and its participants believe it is no longer susceptible to collapse (think March 2000) or will collapse (think March 2009).

After an enormous market rally there are now signs that the rally was largely due to government stimulus as opposed to sustained private sector health.  The analyst community appears convinced that this is a self sustaining recovery.  This makes me wonder if we haven’t overshot to the upside once again?

(figure 2)

My Expectation Ratio (figure 3), which is a leading indicator of the strength of corporate balance sheets when compared to consensus analyst expectations, is currently still showing a relatively robust outlook for profits, however, if the above holds true we could be at a critical point in the cycle.  The ER has shown a distinct long-term downtrend since Q4 of last year and represents the peak level of optimism in corporate profits.  If the macro economic data continues to disappoint to the downside (as JP Morgan suggests) then it’s clear that analysts have been fooled into believing that the stimulus and 80% rally are self sustaining.  However, sustained macro weakness will certainly impact corporate balance sheets at which point the downtrend in the ER would likely become more pronounced (as was the case in 2008).

(figure 3)

The key component holding this market together is the continuing strength of earnings when compared to expectations. The continued optimism in the analyst community leaves the market extremely susceptible to losses at this point in the cycle.  Earnings are the linchpin holding it all together which leads me to believe that the market’s greatest threat at current levels could very well be Wall Street itself as analysts continue to forecast robust earnings and macroeconomic growth in an environment that is looking increasingly fragile.