Home > Finance, The Market > This Rally is Not Just Smoke and Mirrors

This Rally is Not Just Smoke and Mirrors

Well the time has come and the inevitable pullback is most likely upon us, or is it?  It appears as though we are due for a drop at this point in time, and such action would very much be welcome.  Whether this dip lasts for a day, week, month or just an afternoon is a different question, but this morning the lack of breadth on the market’s bounce was quite telling.  Some short-term downside would make sense.

All that being said, many remain confused about what we market participants (and observers) have witness over the past few months.  Considering my recent absence from the blogosphere, I had quite a few thoughts to get off of my chest, so let’s get started.

Back in the early days of the rally, on September 21st to be exact, I wrote out the Top 5 reasons to Trust This Rally.  At the top of the list was the fact that “In the long run, the market follows the trajectory of earnings.”  Not only did companies beat handily on the bottom line, a trend that started several quarters ago, but also, more companies have beat on the top line this quarter than at any point since 2006.  The beats are so strong that some now question whether companies are gaming the top line as they do bottom line (i.e. the standard lowball guidance in order to setup the slam-dunk beat).  Bear in mind, these are the very same people who all along have questioned the quality of earnings beats considering the lack of revenue growth.

In reality, companies issued their latest guidance in the face of pervasive “uncertainty” and at a time when many feared a double-dip recession to be imminent.  It should come as no surprise that amidst an acceleration in the rate of recovery, companies would make more money.  This is consistent with the strong PMI and ISM data to hit the tape over the past month.  These strong revenues help fuel further gains in EPS, above and beyond those that had been cynically attributed to cost-cutting.

But let’s get to the real meat of the point–why exactly should this translate into an epic market rally that leaves technicians searching for answers?  Many want to “blame” QE2 and say that the market cannot function normally in the face of a liquidity surge into markets.  Sure QE2 was helpful, but let’s be honest, it is far too soon for QE2 to translate into revenue and earnings gains for corporations.  It only started during the last quarter.  Yet despite this rally, many companies remain rather modestly valued on many valuation metrics (sure there are some outliers, as there will always be).

The real answer lies in three letters, TTM: the market’s trailing twelve month P/E ratio.  See, the fourth quarter of 2009 saw earnings hit their lowest levels seen in the Great Recession, yet that quarter continued to show its face in the form of elevated P/E ratios at just about all corporations.  With this quarter’s earnings report, we can finally remove that albatross of a quarter from the TTM P/E ratio and get a much cleaner picture as to the earnings power of many corporations.  While guidance during the last quarter helped give a clue as to what to expect, the earnings results themselves, and the magnitude of the beats both top and bottom line, give concrete confirmation to that effect.

Add to that the fact that the pervasive uncertainty that ruled the Summer has now given way to the animal spirits of optimism and the picture looks dramatically different.  It’s the speed with which this all happened that’s thrown people off.  Just as we unwound in dramatic fashion following the collapse of Lehman brothers, these days we are quickly climbing out of that crater.

If today does mark the beginning of a short-term pullback, patient investors should welcome the opportunity with open arms.  We have far more clarity about the normalized earnings power of many companies, we also have a much clearer idea as to which industries are best positioned to weather a storm in the financial sector.  This is all important information that fuels confidence in the longer-term equity holders to hang on and innocent bystanders to seek an entry.  In the short-run emotion reigns supreme, but in the long-run patience prevails.

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