Monday, February 27, 2012

Stock Market Decline Likely

Among the many factors that affect the stock market, two of the most important are corporate earnings and market psychology.  Both currently are neutral to negative.

In both cases, expectations among market participants are crucial in determining the direction of stock prices.  High expectations make high returns unlikely, while low expectations make high returns likely.  When corporate earnings are expected to rise sharply, stock prices have produced poor returns historically. I've noted that consensus expected earnings growth for 2012 have come down, which is a good thing.  However, an examination of earnings revisions on an individual company basis show neutral to negative conditions, with only a small number of prominent companies showing positive revisions.

I consider market sentiment to be the most important market factor over short to intermediate periods.  (Valuation is the most important factor over long periods.)  Unlike the neutral-to-negative condition of earnings revisions, market sentiment measures currently are highly negative for stock market returns.  Sentiment measures now indicate high levels of optimism, which historically has led to negative returns for stocks.  I won't conjecture what specific developments might be attributed to a decline in stock prices (high oil and gasoline prices have been frequently cited by others recently).  I just think that conditions are primed for a decline in stock prices.

The indicators that I follow are such that my asset allocation model now warrants a significant reduction in stock holdings (and to a lesser extent gold) and an unusually high level of cash reserves.

Steve Lehman

S & P 500:  1370

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