Stock Investors Are Far Too Bullish

Signs of stagnation in corporate earnings growth...

 

IF ONE were to look at the current state of the US stock market, because of the substantial run-up in prices, one would think that investor sentiment is being based on the bullish opinion that corporate earnings will continue to rise, writes Sasha Cekerevac of Investment Contrarians.

 

However, a look below the surface would reveal that corporate earnings are not growing anywhere near the levels necessary to sustain the current enthusiasm in investor sentiment.

 

The corporate earnings estimates for the second quarter of 2013 are currently 1.1%, which is a drop of approximately 75% from earlier estimates of 4.3% made by analysts for that quarter. (Source: FactSet, June 14, 2013.)

 

If corporate earnings do come in at 1.1% for the second quarter, while that would be the third consecutive quarter of growth for corporate earnings, eight of 10 sectors will see a decrease in corporate earnings growth. With 86 companies issuing negative guidance for corporate earnings during the second quarter, as opposed to 21 issuing positive guidance, corporate earnings are clearly stagnating.

 

It appears that investor sentiment is far too bullish regarding the underlying fundamentals of the economy. As I mentioned previously, much of the move up in the stock market has not been based purely on corporate earnings growth; rather, the upward momentum has been due to investor sentiment fueled by the Federal Reserve's aggressive monetary stimulus package.

 

A great example of the dichotomy between investor sentiment and the underlying corporate earnings is the technology sector.

 

 

By looking at the chart of the NASDAQ above, it is obvious that investor sentiment has moved into the bullish camp. However, corporate earnings are telling a different story.

 

According to FactSet Research System Inc. (NYSE/FDS), corporate earnings for the information technology (IT) sector are set to drop by 6.3% during the second quarter. Even after taking Apple Inc. (NASDAQ/AAPL) out of this index, as that company is a large contributor to the drop and will see a sharp decline in its corporate earnings, the technology sector is still set to see a decline in corporate earnings of 3.1%.

 

In fact, corporate earnings for the technology sector have been relatively weak over the past couple of years. Yet looking at the chart of this index, investor sentiment has been extremely bullish.

 

This bullish sentiment is not only in the technology sector, but the market in general, which has led to a valuation for the market above its long-run trends. The market's current price-to-earnings ratio of 14.2 is higher than both its five- and 10-year averages. 

 

If corporate earnings were set to generate high growth rates going forward, then the current level of investor sentiment might be warranted. However, with guidance for many sectors being negative on corporate earnings growth rates, this leads to the conclusion that investor sentiment is fueled primarily by monetary policy.

 

The danger is that this aggressive level of monetary stimulus will not last forever. I think it is highly likely that some form of a reduction in the asset purchase program will be enacted later this fall or early next year; this shift in monetary policy will also bring a shift in investor sentiment, which I believe will lead to a substantial market sell-off. With corporate earnings not growing rapidly, there is very little left to keep investor sentiment bullish later this year.