The Major Disconnect In The Market Right Now…

Among the research I read every week is an update on earnings estimates from FactSet. This week, the report included a startling chart.

The solid line represents earnings estimates for the current quarter for the companies in the S&P 500. The dashed line is the price change in the index.

Notice the sharp divergence between the two lines.

Source: FactSet

Since the end of March, when the current quarter began, earnings estimates have decreased more than 35%. The S&P 500, meanwhile, has increased almost 20%.

Why Is This Happening?

There are few arguments for why stocks are going up when earnings estimates are being sharply pared back.

One is that the stock market is forward looking and is forecasting a return to normal earnings growth in the next year. That’s optimistic, and, in my opinion, unlikely.

Another argument for the bulls is that the worst is behind us. That one is actually most likely true. When employment data is announced on Friday, according to CNBC, “the unemployment rate is expected to jump to a staggering 19.8% from 14.7% in April.”

Traders expect this spike in unemployment to be short-lived. However, they are also pricing in a rapid economic recovery. Again, that’s optimistic and, in my opinion, unlikely.

A third argument for the bulls is that there is no alternative to stocks, an idea affectionately referred to as TINA. With the Federal Reserve buying bonds, rates are low and falling.

Source: Federal Reserve

Above is a chart of Moody’s high-quality corporate bond yields based on bonds with maturities of at least 20 years. These bonds are relatively safe and offer investors an opportunity to lock in gains of about 2.1% for the next two decades.

Junk bonds offer an average yield of about 7%. But defaults are also to be expected, which means a portfolio of junk bonds could end up returning significantly less than 7% when accounting for losses.

And we are already seeing losses in the junk bond market. Last week, the car rental company Hertz filed for bankruptcy. The company reported about $19 billion in debt, much of it junk bonds including hundreds of millions in junk issued in November that never delivered a single interest payment to investors.

Hertz is just one high-profile company seeking bankruptcy protection in recent weeks — but it won’t be the last. The coming wave of bankruptcies will wipe out billions of dollars of value for bond holders. This makes stocks, by comparison, more appealing.

But not all investors are afraid of risk. In the case of Hertz, the company’s largest investor, Carl Icahn, suffered a $2 billion loss.

CNN noted that “Icahn had little reason to hold onto his shares. Shareholders are typically wiped out during the bankruptcy process, since they are at the end of a very long line of people owed money. So the decision to sell wasn’t a tough one.”

The “Dumb” Money Is Helping The “Smart” Money

That article raised an interesting point – the stock price of Hertz is likely to go to zero. That leads to the question of who bought Icahn’s shares. Well, some of them went to the investors of app-based brokers like Robin Hood. The chart below shows interest in the stock spiking sharply as the company entered bankruptcy.

Source: RobinTrack

Buyers appearing at Robin Hood when a company enters bankruptcy is a recurring theme, as the next chart shows. The chart below is for Tuesday Morning, a retailer that filed for bankruptcy last week.

Source: RobinTrack

Buyers are moving into stocks based on hope and greed rather than solid earnings prospects. Uninformed investors are helping smart money like Carl Icahn unload shares in bankrupt companies.

Looking Ahead

This is an indicator of an unhealthy stock market. The only reason stock prices appear to be rising is because investors are chasing gains in stocks since there is no alternative. It can’t last unless earnings turn around… and the prospects of that are dim.

I believe we should continue to expect a selloff in stocks, and I expect the selling to start soon. I would not to be surprised to see a strong rally followed by a retest of the March lows. However, until prices start falling, we should continue to selectively take positions in stocks that are moving higher.

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