Is The Party Over For Stock Markets?

Is the party over?

From a quantitative perspective, it looks like it might be. The biggest indicator of the downtrend is the weakness in the Dow. The world’s most closely watched Index has closed below where it opened for five out of the last six trading days. The market failing to hold on for a few hours to any gains is never a good sign.

The fundamental side doesn’t look much better either. Seven banks failed over the weekend. The total now sits at 106. The next “reality check” looms just around the corner. Official unemployment numbers are slated for next Friday. There’s no one on Wall Street or in the government left who doesn’t believe official unemployment is going to 10%.

Even the one stock almost all of Wall Street has a heavily vested interest in to keep propped up is starting to fall. The recently IPO’d battery maker A123 Systems (AONE) has fallen almost 40% after getting within $1 of our price target.

Even the most optimistic investors don’t have very many positive catalysts to point to for the markets to go higher. At this time, however, I’d still be hesitant to stick a fork in the rally quite yet. Here’s why.

Confidence Low and Fear High

There are no perfect stock market indicators, especially when it comes to sentiment indicators.

There are, however, some ways to get a good idea of market sentiment. One of those is Robert Shiller’s Crash Confidence Index (CCI).

The Yale professor’s CCI is based on a survey of institutional and high income individual investors. The survey asks respondents what they believe the chances of a catastrophic stock market crash (like the 1929 or 1987 crashes) are in the next six months. The CCI is then calculated by taking the percentage of respondents that think the odds of a crash are less than 10%.

Basically, the greater the CCI reading, the fewer investors expect a crash.

The chart below shows the CCI readings for institutional (blue) and individual (red) investors since 2001.

As you can see, the market always seems to do what most don’t expect. When confidence is low, like in 2002 and early 2009, the markets climbed. When confidence was high in 2006 and 2007…we all know how that turned out.

That’s why I’d hesitate against battening down the hatches just yet. The CCI has recovered from its March lows, but it’s still not much higher than its levels from the confidence index lows of 2002 and 2003.

Remember, the markets are a lot like teenagers. Confidence takes years to build, but can be quickly shattered. Right now it’s still rebuilding and will take a long time to do so.

Setting the Bar Low

It’s not just confidence and hubris which leads to sharp downturns, there’s also expectations. As we always say, great expectations inevitably lead to great disappointments. Right now it’s tough to find great expectations anywhere.

That’s why this earnings season, as long as it’s not absolutely dreadful, the markets should be just fine. In fact, CEOs, Wall Street analysts, and traders are all going a long way to make sure the worst-case scenario does not play out.

Consider this. As of last week, 80% of S&P 500 companies beat consensus earnings estimates…80%!

So what’s going on? Is the economy much better than most believe? Are executives doing a great job at running their companies?

Well, executives may be doing an amazing job, but they’re doing a great job of keeping expectations low.

Now, we all know CEO’s keep expectations low. It’s nothing new. It’s not some grand conspiracy either. It’s just how it’s done. But here’s the part most investors miss.

Analysts’ expectations still matter.

A recent study from Northwestern University’s Kellogg School of Management found that between 1994 and 2007 analysts’ estimates were the second most influential factor affecting price movements. The only more influential factor was CEO guidance and comments.

So here’s the deal when it comes to earnings. As long as expectations can be kept low, we should be in the clear for each earnings season. When expectations get a bit too far ahead of what the companies can actually deliver, that’s when you wake up to see big blue chips stocks falling 10% in a day.

Also, we can’t forget these are “earnings” too. They’re the most easily manipulated number in accounting. That’s why for investors looking to determine a true health of a company they should look at operating margins. They don’t lie.

Growing into the Market

So there are two reasons which should significantly decrease the likelihood of an all out crash.

In fact, real, genuine, positive news is starting to come out. For instance, the recent National Association for Business Economics (NABE) survey revealed more companies were looking to hire new workers than were looking to continue to trim staff. Although not great, it’s certainly one of the first real recovery signs we’ve seen yet.

On top of that, there’s the next big story for the markets. I know it’s only October and no one is talking about it yet, but holiday sales season is just around the corner.

Expectations so far are pretty low. The National Retail Federation (NRF) predicts retail sales to fall one percent from last year’s total. All considered it’s not too bad. But more importantly, it’s an achievable expectation.

In the end, I really think the big party where everyone was invited is over. The dot-com style rally where everyone makes money is probably done. Now, there’s going to be two groups of investors: successful and unsuccessful. That’s why now it’s more important than ever to keep an eye on the big picture, don’t get emotionally attached to any position, and keep a close eye on expectations and you will do just fine.

Subscribe by RSS Subscribe by Email

Comment by joe

2009-10-28 02:32:37

don’t hate..appreciate. some people are more skilled than you gave credit.

Reply to this comment