Feb
06

Overdue Correction Finally Arrives

Posted February 6, 2018 by
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Time to read: 4 minutes

This week, we drafted our latest report titled Irrational Exuberance, in which we reinforced our belief that equity markets were due for at least a 5% pullback.  Before the report was approved for release, that market correction was realized in short order.  See our recent commentary Record Streak Without Correction…Now What?  and our 2018 Market Outlook.  We argued that investors should expect increased volatility, take steps to manage behavioral risks, review concentrated stock positions, and make sure asset allocations were aligned with each client’s investment plan.

It was also our position that a 5-7% correction was overdue, but not necessarily a tradable event.  Instead, we choose to closely watch our short-term indicators before making portfolio shifts.  As of the time of this writing, our tactical rules continue to support the current asset allocation for each of our portfolio models.  This could change quickly, warranting a more defensive posture.  But that hasn’t happened yet.

We do think it’s worth highlighting one positive trend, however, which may help act as support for a euphoric market that’s beginning to blow off some steam.  The chart below shows analysts’ consensus projections for S&P 500 earnings per share for calendar years 2012 through 2018.  The average equity analyst tends to start each year with excessively rosy expectations for corporate earnings which are progressively tempered over time.  These downward revisions can clearly be seen in the chart.  Many investors may be surprised to learn that since 1984, analysts have started the year overestimating corporate earnings by 8%, on average.

The anomaly in the upper right corner of the chart is this year – 2018.   Over the course of January 2018, analysts have revised their projections up from $145.36 to $150.57.  These predictions are based in part on corporations’ reported earnings and the response to the recently passed Tax Cuts and Jobs Act of 2017.

As of this writing, the companies that make up the S&P 500 are only a few weeks into the first earnings season of 2018.  It appears that the market (or at least the average equity analyst) may have underestimated the benefits of the tax package on corporate earnings growth.  As equities correct after a period of excessive optimism, expectations for higher corporate profits should help…