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Earnings season is here again, which provides a timely reminder that earnings are the ultimate driver of stock prices. The following article examines the recent trend in equity prices and earnings estimates and discusses the implications for the equity markets.

Earnings and Equity Prices Diverge

FactSet is a leading vendor of market analytics, financial and market data, financial screening tools and customized solutions. They also provide a comprehensive, detailed analysis of earnings and earnings trends, which they offer via free weekly PDF files on their site. The earnings graphs in this article are from the latest FactSet report.

Equity prices and earnings forecasts diverged before Q3 2012 earnings were reported; prices rose dramatically while earnings forecasts declined. This preceded a significant market pull-back in the fall of 2012. Unfortunately, we are seeing the same troubling behavior again this quarter. As you can see in Figure 1 below, equity prices have increased by roughly 8% in the past two months while bottom-up EPS estimates for Q4 2012 and Q1 2013 declined by 1% to 2%.

(click to enlarge)Figure 1: Factset EPS versus Price Q412 & Q113Figure 1: FactSet EPS (Q412 and Q113) versus Price

While not as extreme as last quarter, the Price-EPS divergence for the past 12 months is still alarming. Over the past 12-months, the S&P 500 is up roughly 17% and year-over-year Q4 EPS estimates for the S&P are only up 1.5%. This obviously means that P/E ratios are rising. According to FactSet, forward 12-month P/E ratios are now above their 5-year average.

Unrealistic Growth Expectations

The Q4 2012 EPS estimate of 25.15 (which has since been revised lower) is slightly above the Q4 2011 estimate, but earnings have essentially been flat since Q3 2011. Now look at the earnings forecast for the upcoming 12 months (Figure 2 below). Earnings are expected to grow approximately 19%. The Trader Edge recession models are not currently indicating a U.S. recession, but 19% EPS growth for the next 12 months seems remarkably optimistic.

Companies have slashed costs over the past few years, wringing every last penny of profit out of every dollar of sales. As a result, future earnings growth will need to be generated primarily through top-line revenue increases, which will be difficult to achieve given the weakness in Europe, Japan and the slowdown in China.

(click to enlarge)FactSet Actual and Estimated EPS Q412Figure 2: FactSet Actual and Estimated EPS Q412

There is no question that the market responded favorably to the temporary fiscal cliff fix, but the fiscal cliff still exists, as does the debt ceiling. There will be more tax increases and probably some spending reductions as well. While accepting fiscal responsibility is prudent from a long-term perspective, it will create incremental drag on the economy and earnings in the near-term. This will make it even more difficult to achieve 19% EPS growth in the next 12 months.

Equities Overbought

The unrealistic earnings expectations are worrisome, but the technical picture is equally problematic. All of the broad market U.S. equity indices are at or above their monthly R2 pivot resistance levels. This has historically led to pullbacks or at least periods of consolidation. The top panel in Figure 3 below is a daily candlestick chart of the S&P 500 index with monthly pivot (support and resistance) lines. The top line (dark green) is the monthly R2 resistance line.

The bottom panel depicts a proprietary Trader Edge market breadth oscillator. The market breadth oscillator is currently above the bearish extreme threshold, implying an increased risk of a reversal. Note that a similar situation occurred in mid-September of 2012, shortly before Q3 earnings season.

(click to enlarge)S&P 500 Index through 01-11-13

Figure 3: S&P 500 Index through 01-11-13

Conclusion

Equity prices and earnings have diverged over the past two months and over the past year. In addition, earnings growth expectations appear to be unrealistic, especially given the current state of the global economy and the incremental drag of austerity measures in the U.S. Finally, equity markets are currently overbought, suggesting market headwinds in the near future.

Source: Price-Earnings Divergence Suggests Market Pullback