Use the Numbers to Fathom Markets

 | May 08, 2013 | 9:00 AM EDT
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The stock market rally is being given the moniker of the "most hated rally ever" -- although most rallies are disliked to one degree or another.

Every reason under the sun is offered for why stocks should go up, or down, despite or because of, the economy is recovering or faltering, with employment gaining or declining. The conflicting analysis is driving me nuts and the market continues to rise every day. A few pundits are even declaring this the start of the next great bull run, similar to the 1980s or 1990s. When I just can't stand the anecdotal analysis anymore, I do what every good investor should do: go to the numbers.

My opinion on the economy really does not matter because the economy does not really matter. Stocks care about one thing and one thing only: earnings. For context, consider this. High unemployment could hurt demand -- except if demand is coming from overseas for exports, in which case high unemployment lowers wages and improves margins. The economy can be anything, but if earnings are getting better, then higher stock prices are justified.

Knowing this, however, is why this rally has me quite nervous. I have been tracking the change in the 2013 earnings estimate for the S&P 500, because an ongoing rally can only be justified if the earnings come in better than expected. Estimates not being raised means analysts are not detecting incrementally better conditions. If estimates are being cut, they are certainly detecting incrementally worse conditions!

The latest installment of my price versus estimate chart should give you pause.

S&P 500 Table

This jaws-like gap is unsustainable, based on everything I know about how markets behave. Either earnings will have to be revised up, confirming the bullishness in stocks, or the rally will falter. The "falter" could be a long, slow decline, or a sharp one-day drop like we saw in 1987 and 1989. I have no idea how a correction might develop, but with earnings not behaving correctly, this rally should be extremely suspect to the informed analyst.



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