Why You Can't Short This Market: The Expectation Ratio

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 and 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 1,000, 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.

Author's disclosure: None

Comments

[j-dub]

Much like the ubiquitous Time Magazine cover that would have a family of bulls sitting in a fine restaurant looking at a menu detailing 9+ ways they serve bear meat, your logical and thought out editor's pick article MIGHT be the perfect contrarian indicator for any avid SA reader.

2009 Nov 19 07:28 AM

[logicalthought]

>>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.<<

1) You might want to wait for the Q3 GDP revision before you call the figure "great". 3.5% will revert back to 2.5%-3% (and that, of course, INCLUDES "cash for clunkers").
2) Now that Obama has (seemingly) found "budget deficit religion", you can say goodbye to the extra government spending that juiced the above stats.

>>...very negative earnings expectations continue to provide support to the market.<<

So, you think consensus S&P 500 operating earnings for 2010 of $75 is "very negative"? Personally, I think it's "very fantasyland".

2009 Nov 19 08:01 AM

[Moon Kil Woong]

Like China, as long as the government is loose and free with it's monetary policy it will always invite a bubble. That bubble will persist even though we know it's a bubble and the party can not go on forever. Indeed the risk is high but making next to nothing on your money as every asset increases in price is also a very risky prospect.

It is exactly this conundrum the Federal Reserve and Treasury want to give to people in order to encorage some sort of consumption. Unfortunately, it does not consist of buying and consuming goods but encorages hoarding and asset speculation exclusively. This fundamentally is the hallmark of a bubble's undoing, for it leads to inflation and the abrupt end to easy money or the ability of people to be able to afford even the most basic essentials if the government does nothing about it.

If you can call the end of the Fed's easing the market is shortable. Otherwise it's not. I guess we can watch Goldman Sacs since they magically know in advance what way the government is going to do these days.

2009 Nov 19 08:04 AM

[TheFounder]

The author suggests that you can't short the market because it may continue its way up. But he is convinced at some point it will go down again. What is the point in trying to guess the exact top point of the market? why not just start to establish a short position and add to it on new tops?

2009 Nov 19 08:08 AM

[Faisal Humayun]

shorting a liquidity driven market is always a dangerous idea...Things might look expensive but still go up...Moreover, there are a hell lot of people out there who are still skeptical about the rally...Generally speaking, when the sentiment is very bullish, it is the time to short...the same is not the case now...still you have many bears out there...

In March, no one wanted to put their money in the markets...Since then we have gone up more then 50%...So very bullish or very bearish times are the best times to go contrary...

We have none now...markets seem to be confused about the direction in which the economy is headed...

2009 Nov 19 08:24 AM

[fwi]

It doesn't matter that people Say that they are bearish, or that this market worries them. THe majority ot traders and/or investors have Obviously been trading as bulls. THe ubiqutous CNBC talking heads and the financial press are just full of people talking bearishly because it sounds thoughtful, but they are trading with both fists because so is everyone else.

The smart money used to say "It's the economy, stupid". It now says "It's the performance, stupid". That is all that is happening. And it keeps happening until it doesn't.

2009 Nov 19 08:37 AM

[recession graduate]

equities are more often than not just a child of credit and with the doveish fed I wouldn't expect things to derail in the near future. I discuss my thoughts on the long risk/short dollar rally on my blog.. some of you might have interest.

2and20vision.wordpress.../

2009 Nov 19 09:10 AM

[SeekingTruth]

Good insight overall, and well explained.

There is , however , one area of investing that needs to be better acknowledged and covered, that while enormous in its effect, is overlooked by "most" investor's that focus on traditional things like earnings and earnings expectations, etc. all important , to be sure, but not even close to being enough.
The major insiders know these things (below) well in advance which is why they stay several leaps ahead of the general public.
That subject involves the intersection of Wall Street and Constitution Ave, and we need a major category name for it , and better tracking and advance warnings which I will be working on, and I hope others will also.

Consider when this huge rally started :

It started when word got out that FASB chairman Robert Herz, under massive congressional pressure, was to announce that "Mark to Market" (M2M) was to be suspended, which they in fact did suspend , almost simultaneously with the start of the sharp and dramatic part of the rally in early March (9th).
"Mark to Market" then became :

Mark to My Magic Marker

Which then meant that the banks could write their own ticket for valuing their own toxic assets and avoid insolvency , virtually, by "hook or crook" as my old math teacher used to say.

The market knew that the rules would greatly effect balance sheets and allow "creative accounting" and "earnings expectations" like no one ever dreamed of with added opaqueness replacing what little transparency that existed.

OK, this is a much bigger subject than I can properly address here, and I have volumes in my own mind, and I only wished to raise the subject so that we could better and more fully address these things here on SA, along with the more traditional approaches so often taken like the kind so well addressed in this excellent article.

2009 Nov 19 09:21 AM

[mcl_mixer]

"Ever since our March 8th bottom call, I have maintained that the market could not be shorted."

Perhaps you should read your own writings.

seekingalpha.com/artic...

2009 Nov 19 10:36 AM

[David Van Knapp]

Just what is the "Expectations Index," exactly? How is it computed? What factors go into it? Absent that information, the value (or lack of value) of the Index is unknowable.

I disagree that with the end of earnings season, the fuel for the rally is over. The fact is, this rally has been going on since March, through three earnings seasons. The rally, IMO, has been based on a "net news flow" that has been interpreted as positive by the majority of market participants. That's why the market has been going up. Of course it is true that during earnings season, there is lots of news about earnings. But between seasons, the news flow does not stop, it continues daily--economic statistics, M&A activity, Leading Indicators, speeches by Fed governors, appearances before Congress, presidential addresses and interviews...the list is endless.

Deep Throat said, follow the money. "The money" has been buying stocks, that's why prices are up over an 8-month span. There are plenty of arguments to be made against it (not supported by fundamentals, etc.), but everyone who has been bettng against this market rally has gotten hammered. There has been a massive self-inflicted transfer of wealth from people who have been playing the short side to people who have been playing the long side. In his/her comment above, fwi has it exactly right: It will keep working until it doesn't.

To The Founder (above). The reason not to "just start to establish a short position and add to it on new tops" is that those are losing bets until the trend changes. Follow your own advice in not trying to guess the top of the market--it may be a long way off, and in establishing short positions, you are doing exactly what you are counselling against: Guessing that there will be a top coming soon. Of course there will be at some point in the future, but there will be plenty of time to react to it after it becomes clear that it has happened. In the meantime, just protect our profits with tight sell-stops, and continue to ride the current trend for as long as it lasts.

2009 Nov 19 10:44 AM

[SeekingTruth]

While I agreed with this article "overall", I think readers should go back and read the author's article: "Risk/Reward in a Bear:" to put his current info in a more balanced framework and perspective.

2009 Nov 19 11:19 AM

[Ricard]

1) "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. "

There are a couple fallacies here. Yes, we are 10 years into our bear market, but the original 'bear' was not fueled by excessive debt. In that sense, the current debt-related recession is a very young phenomenon. I'd be apprehensive about lumping the dot-com bust with the housing bust just because the Dow and S&P say so. What is encouraging about our scenario is that we implemented QE immediately, whereas Japan waited 12 years before doing the same. That, and our asset bubble is completely dwarfed by what Japan went through.

2) "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 don't think the fundamentals ever supported a v-shaped recovery. What equities are pricing in, IMHO, is a nominal recovery where GDP shrinks significantly, one we don't feel due to dollar devaluation and inflation scenarios.

2009 Nov 19 11:23 AM

[The Pragmatic Capitalist]

There's a big difference between having a negative macro outlook and trading within that outlook on a micro basis. I was still very bearish at the March 8 bottom, but felt that a long bias would serve me well. You can be quite bullish in the short-term regardless of your macro outlook....I have been bullish at many stages during this rally, but only actually went short on June 1st for a few weeks. I have maintained throughout this rally that it is primarily a government driven recovery and that it could not be stepped in front of on the short side....


On Nov 19 10:36 AM mcl_mixer wrote:

> "Ever since our March 8th bottom call, I have maintained that the
> market could not be shorted."
>
> Perhaps you should read your own writings.
>
> seekingalpha.com/artic...

2009 Nov 19 12:10 PM

[The Pragmatic Capitalist]

I don't ever pretend to have played this rally perfectly. I sold out of my bottom call long position FAR too early and have only gone heavily long on a few other occasions since then. But after calling the crash last year, returning 19% in a -45% year, calling the bottom (to the day), participating in a sizable chunk of the rally's upside and sitting on an all-time high I think I have the right to defend my long-term record. Of course, SA readers only get to read what the SA staff picks off my site so the calls aren't easy to follow here.....

I don't pretend to get all the calls right, but my risk adjusted returns and calls have been good. The overall premise of that article was spot on in my opinion:

"I believe hedging strategies will achieve good risk adjusted returns in the coming months."

PS - article should say that I recently sold at 1,100....


On Nov 19 11:19 AM SeekingTruth wrote:

> While I agreed with this article "overall", I think readers should
> go back and read the author's article: "Risk/Reward in a Bear:" to
> put his current info in a more balanced framework and perspective.

2009 Nov 19 12:21 PM

[thiazole]

"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."

To some degree, that is a contradiction. If the future earnings estimates are being lowballed, that means that future P/E ratios are being overstated which means the rally is BEHIND fundamentals. I realize that by "fundamentals", that you are referring to trailing P/E ratios, but I don't know any investors who care more about last year's earnings than next year's earnings.

2009 Nov 19 12:21 PM

[ryanclarke]

You mention a 2009 earnings forecast of $45 ... when the analyst were predicting $60. Q1 was 10 ... Q2 was 13 ... Q3 looks to be about 16 ... for a total to date of about $40 of earnings. If the banks don't "writedown" in Q4 then the $60 is correct and the market is currently "underpriced." But if the banks do take losses in Q4 then the $45 forecast you made earlier in the year may, in fact, be generous ... my point being, that in no prior period of Mr. Market running his business on Wall Street ... have earnings outcomes been so manipulated by those who don't work on the street.


On Nov 19 12:10 PM The Pragmatic Capitalist wrote:

> There's a big difference between having a negative macro outlook
> and trading within that outlook on a micro basis. I was still very
> bearish at the March 8 bottom, but felt that a long bias would serve
> me well. You can be quite bullish in the short-term regardless of
> your macro outlook....I have been bullish at many stages during this
> rally, but only actually went short on June 1st for a few weeks.
> I have maintained throughout this rally that it is primarily a government
> driven recovery and that it could not be stepped in front of on the
> short side....

2009 Nov 19 01:03 PM

[phdinsuntanning]

certain folk visited Tokyo,
Mr. Yen said: hi Im broke,
then the guy jumped to China,
and they told him: credit nope.

So he called is barbed printer,
better old on on the dope.
Party is over for some timing,
till our owners give us hope.

Short those bars and black refined,
tell our gold men there is no hope.

Certain folk you got the tough job,
just when party came to stop.
I dont envy your position but you
still have some good hope:
balance budgets and bring soldiers
to the peace of moms and pops.

2009 Nov 19 02:58 PM

[thiazole]

Based on all the thumbs down I got for making this statement, I take it back. The kind of investor who has completely missed the rally (aka, the majority of SA posters) believe that trailing data is more important than future data. Those of us who actually MAKE money investing look to the future. I forget how rare sensible investing is here on SA and I apologize to all those who were offended by the notion that the future is more important for future returns than the past.


On Nov 19 12:21 PM thiazole wrote:

> "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."
>
> To some degree, that is a contradiction. If the future earnings estimates
> are being lowballed, that means that future P/E ratios are being
> overstated which means the rally is BEHIND fundamentals. I realize
> that by "fundamentals", that you are referring to trailing P/E ratios,
> but I don't know any investors who care more about last year's earnings
> than next year's earnings.

2009 Nov 19 03:12 PM

[DormRoom]

you can start shorting the market now, because of this news

Paul-Grayson Amendment To Audit The Fed Passes Overwhelmingly By 43-26.

Once investors look under the Kimono, they may be terrified by the what they see. Someone had to get their hands dirty to prop up the market. And the Fed had a badass hand.

It'll be interesting to see the perma-bears' reactions when the market crashes, depression 2.0 starts, city crime rates hit 20%, riots, and looting occur. Instead of your invisible hand correcting the market, there be a hard fist of anger, and resignation against the propertied, and monied class.

Bears, how you gonna get to the bank and count your winnings, if you're gonna get robbed 10 times before reaching it.

Furthermore, I wonder if there's a correlation with this news, and the negative 3-month Treasury Yield today. Someone knows something.

F*ck, I can't believe they passed this amendment.

2009 Nov 19 10:36 PM