S&P 500: What Are We Really Chasing?

| About: SPDR S&P (SPY)

Summary

Investors may be pushing the market up in panic buying, powered by easy liquidity.

Overoptimistic earnings forecasts need to be understood well.

The market seems disconnected from the earnings.

Stock bulls have been the clear winners in the aftermath of Brexit. The market has climbed on to new highs, and the momentum isn't fading. The confident participants are buying even the slightest dips, and scooping up stocks which have even the faintest chance of producing good returns, regardless of how their respective businesses are performing.

S&P 500 (NYSEARCA: SPY) recently hit a new 52-week high of 2175.63 as the market became flooded with talks of earnings rebound in the second half of the year. Bulls consistently fed the "market is forward looking" maxim to whosoever wishing to listen and cited the expected earnings turnaround as the key ingredient to make the recent breakout from a two-year consolidation a success.

Technical analysis assumes that a breakout on the upside is a signal for more gains in the future. This has also led some analysts to give targets ranging from 2300-2400 for the S&P 500. I do not intend to say that this cannot happen, but I am strongly of the opinion that the downside risk is more.

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Source: TradingView

In a market with strong bullish momentum, it is hard to justify a cautious outlook, because possible upside potential tends to overshadow weak fundamentals. Liquidity may prove to be the king in the short-term, and earnings and fundamentals both take the back seat. The bearish thesis, even though good enough to warrant some time and consideration, faces constant criticism as the market attempts to take out new highs led by irrational exuberance.

Note: Nobody should make contrarian bets on a momentum market.

It seems awfully hard to establish what irrational exuberance means when the markets are rising. Till the time the markets are rising, it is all justified on the basis of forward earnings. Only when the tide has turned against us do we realize that we bid too high a price for something far into the future. The same happened before the tech bubble burst and during the pre-2008 crisis. If the same is happening now is open to debate.

In this analysis, I will focus on only one thing: earnings estimates. Since it is hard to gather what levels of stock prices will be considered bubble valuations in the era of abundant liquidity, we must at least establish that earnings estimates are not a reliable tool when considering an investment decision.

The chart below compares the change in price of S&P 500 versus the change in forward 1-year earnings estimates. It can be seen that the expected SPY earnings for the next 12 months - $127.62 - is still below the end-2014 level. The market has seemingly decided to disconnect from the earnings expectations as it remains awash with liquidity.

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Source: FactSet EarningsInsight

The forward 12-month PE ratio at the current level of 2168.48 is ~17. The ratio is significantly higher from its 5-year average forward PE ratio of 14.6, and above the prior 10-year average forward PE ratio of 14.3. This implies that earnings will really have to catch up in the future, if investors don't get too consumed with easy money.

Will Earnings Really Catch Up In H2?

It is only imperative that we discuss how accurate the analysts are when predicting the earnings. For the third quarter earnings, analysts at the beginning of April suggested a 3.3% increase. This looked very convenient at that time, but since then, multiple downward revisions have dragged the EPS growth rate to below 0 percent now. To be clear, they now expect a decline of -0.1 percent.

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A couple more of the infographics reveal how the analysts who were so confident about an earnings rebound in the second half of 2016, quietly toned down their estimates.

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After the markets had recovered from their Feb lows, several research firms and their bright minds began pumping the higher EPS estimate numbers for the investors to consider the bullish scenario, even as they kept their own dismal record hidden. What's more frightening is that the investing community continues to heed their pompous talk, and participate now when the market is relatively overvalued by several metrics, and warrants a steep correction to offer the now forgotten the basic principle of investing - margin of safety.

If this doesn't convince you that the future earnings should not be trusted may be this will. Over the past five years (2011-2015) at the end of June quarter, analysts had overestimated the actual earnings growth for the 2nd half of the year by a staggering 4.7 percent.

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Source: FactSet MarketInsight

For the second half of 2016, consensus is of a 4.2 percent in earnings, but if this average overestimation is adjusted to this figure, the actual earnings would be -0.5 percent. Only time will tell if history will hold this time as well or not, given that it is such a small time frame to reach a strong conclusion, however, investors must definitely become more cautious, and adopt a careful stance. The market cannot keep trending higher forever in the wake of disappearing profits.

If the S&P 500 reports a decline in Q2 earnings, it will be the first time since Q3 2008 that the index records five consecutive quarters of YoY declines. Similarly, a revenue decline in Q2 will extend the streak to six straight quarters of consecutive decline since Q3 2008.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.