We’re still early in first-quarter earnings season and Wall Street has already had a nice rally this year. The S&P 500 put on nearly 15% between February 8 and this past Thursday. We could be headed for a cooling off period. Paul J. Lim notes in The New York Times that the market may be getting a tad too optimistic about earnings:
John Butters, an earnings analyst at Thomson Reuters, noted that more often than not, companies that are likely to fall short tend to pre-announce their results, in part to lower the market’s expectations.
Historically, two companies pre-announce bad news for every company that hints at better-than-expected results to come. But at the moment, Mr. Butters said, the ratio is just 1.1 to 1 — which means that far fewer companies than usual are preparing the market for disappointment.
That may sound like a positive sign, but it isn’t. Oddly, when the pre-announcement ratio has been this low over the last decade, it “corresponds with a decline of about 6 percent in the S.& P. 500 during the earnings season,” Mr. Kleintop said. It may be that without an early warning of trouble, investors become too ebullient, leading to market declines later.
Here's a look at the S&P 500 along with its earnings. The S&P 500 is the black line and it follows the left scale. The earnings are the yellow line and they follow the right scale. The two lines are scaled at a ratio of 16-to-1, so whenever the lines cross, the P/E Ratio is exactly 16.
The future earnings are, of course, just a forecast. Be careful not to read too much into this chart. The point I want to show you is that the market has rallied and it’s been due to a surge in earnings that’s expected to continue.
If that yellow line continues its sharp upward trend, then the market is still very cheap and we have nothing to worry about. We ought to assume that the black and yellow lines will converge over time.
The hitch is that this is all predicated on a very strong earnings environment. We shall know more when we’re a little older.