The Market Decline Is Due to the Fiscal Cliff ...

 | Nov 16, 2012 | 8:38 AM EST  | Comments
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Here is a "what if." What if the correction is not due solely to the fiscal cliff? We are all worried about it, and the commentary is never-ending (and I will throw in my next two cents again Monday), so of course that must be the cause, right? As a few folks have pointed out, what changed from a day before the election to a day after? The cliff should already be priced into the market, since its approach was obvious for months. Why would it suddenly matter now?

There are always other forces at work in the market. Perhaps they are equally important? I won't claim to know all the forces in play, but one factor I have been tracking for months is the revision trend in the market-earnings estimate for 2012 and 2013. I discussed this in a post last month, "This Is Probably Unsustainable."

I have noted for the last couple of months that the market rally has occurred in the face of a declining earnings estimate for the S&P 500, which has created a gaping "jaw" that is rarely sustainable. Market price action typically tracks the revision trend: upward revisions drive prices higher, while downward revisions drive prices lower. Starting in July, the market went on a tear even though estimate trends stayed flat. In my experience, these jaws-like gaps are unsustainable -- either the market corrects, or estimates start rising. Look at the latest tracker chart.

Estimates remain flat, and the market decided it was time to give up the summer's gains.  Based on the chart, it seems that the correction could go a bit further.  I don't think we will see a resumption of a rally until estimates start rising, and if they start falling, look out below!

Of course, estimates could be cut if the cliff looks like it will become a reality, so even this analysis is intertwined with macro forces.  The lesson is to pay attention to the cliff negotiations, but also watch the most fundamental factor of all: earnings.

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