The Real Reason Stocks Have Rallied

Wednesday, March 10, 2010

Being on a trading floor everyday I often hear explanations for why the market is rallying or why stocks just won't go down. Frankly, many of those comments are downright silly. I read about 30 different blogs on a daily basis and the majority of them tend to be on the bearish side of things. There was a guest post over at naked capitalism yesterday entitled "6 Theories On Why the Stock Market Has Rallied." The post basically lists the following reasons: dumb money is buying, government stimulus, inflation, algorithm buying, the Fed is on the bid and fraud based on overvaluing assets. This writer misses the most crucial, and actual, reason stocks have rallied: earnings growth!

Stocks will, forever and always, follow earnings growth over the long-term. Earnings were decimated in 2008 as financial companies took massive writedowns on their bad bets and many went out of business altogether. Risk was drastically mispriced by financial firms and for their errors they suffered large losses. But, earnings of S&P 500 companies have rebounded sharply and are approaching all-time highs once again. This is the reason stocks have rallied. According to this chart, stocks are pricing 19 times 2010 earnings expectations. Granted, that is on the high side, but it's far from extreme.

The market is also a forecasting machine which, as we know, typically overshoots to the upside as well as the downside. Ultimately, market prices are dependent on the long-term economic growth yet filled with massive gyrations as participants continually re-evaluate their expectations for the future. The March 2009 lows were marked by extreme pessimism so simply becoming more optimistic allowed stocks to turn and rally sharply. Then, June 2009 earnings season rolled around and the earnings picture supported the move higher. Stocks continued their rebound throughout the rest of the year as the economic landscape improved.

Fourth quarter earnings season started with a sell-off in equities in mid-January. Yet, nearly 3/4ths of S&P 500 companies beat their estimates. Is that not amazing? After a 70% rally in US equity markets, one would expect optimism abound. Yet, analysts are still underpricing their earnings expectations. Stocks bottomed in early February and rallied right back to highs, where we sit today.

Going forward, based on estimates for future earnings, stocks can continue rallying. If analysts are correct, we are looking at 28% year-over-year earnings growth in the first and second quarter. That's huge and should this materialize, a further rally may be supported.

In the end, I have no idea where the market is going tomorrow or the next day. I am not arguing that the market will go up from here. Given the forecasting nature of the market, we could even see a downturn as participants begin pricing an end of year slowdown in the economy. But, short-term trader or not, market participants should always recognize the growth of earnings and not fight it. This is clearly akin to "don't fight the tape". In sum, don't fight the tape especially when earnings support it.
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