Play This Rally With Caution

 | Dec 19, 2012 | 9:30 AM EST
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The market is rallying, presumably on a fiscal cliff resolution, but anticipation of more debt monetization by the U.S. Federal Reserve is probably an equal driver. I start to worry when a rally is not underpinned by the most important factor of all: earnings. A month has passed since we last checked the S&P 500 earnings estimate trend, so let's check in on it now. The revision trend is one of the most powerful forces moving stock prices, and when the estimate trend diverges from the price trend, trouble can often ensue. In mid-November, we noted that a gap that had formed in early September was closing -- the 2013 estimate was flat, so the rally reversed, especially after the election.

However , that gap closure is reversing now. The rally should be sustainable if estimates were starting to be revised up, which would mean that the earnings outlook for the market was getting better on the margin, justifying higher prices. Yet estimates are in fact being revised downward, indicating that analysts are getting marginally less optimistic about prospects for the coming year. If analysts are pessimistic, why is the market be rallying?


S&P 500 Stock Price vs. 2013 Earnings Estimate
Source: Factset using FirstCall estimates


Clearly, the estimate and price trends can diverge, often for legitimate reasons. However, the divergences are rarely sustainable, so you should be very careful playing this rally. If estimates start trending up, let it ride. But if estimates continue to be cut, keep an eye on the door and a finger on the sell button.

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