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Rick Konrad on Expectations Investing

(Guest Commentary by Rick Konrad – April 22, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a quick guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month – but his schedule did not permit him to do that last Wednesday.  Therefore, I have asked him to write a guest commentary for this weekend instead. Thanks, Rick.

For those who like to keep track of the Dow Industrials vs. the Dow Transports – along with our sentiment indicators – you do not need to worry.  I will comment on those (and you will see our usual charts as well) after Rick's writings in this commentary.

In this commentary, Rick will be offering his thoughts on the current expectations for the 1Q earnings season and on what sectors may out perform or under perform in the foreseeable future.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Rick Konrad on Financial Services Companies” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. 

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Once again, we are in the midst of earnings season as first quarter numbers are being reported. Overall, it seems that earnings expectations have been falling relative to prior quarters, but S&P 500 expectations still represent about 8.4% earnings growth, not terrible by historical standards.

Let's have a look at the earnings picture by sector reviewing Q4-06 compared to Q1-07 results:

Earnings Expectations by Sector: http://tinyurl.com/ytn3vl

As you can see, the materials sector has the highest expected growth for Q1 at 15.5%. With expected growth of about twice that of the S & P 500, I wonder how much of these expectations are already incorporated in price. US Economic growth probably slowed during Q1 to somewhere around a 1-2% pace. Domestic new residential construction spending seemed to have fallen off a cliff by some 30%, and US motor vehicle production fell 10%.

At the other end of the expectations spectrum are financials, info tech and telecomm services. Let's delve into some of the history of positive and negative surprises.

Earnings Surprise Trends: http://tinyurl.com/2d6n6q

A few observations that I believe are noteworthy:

  • Earnings surprise data for the industrials sector has confirmed the slowdown in the economy for the last four quarters with positive surprises falling in each of these quarters.
  • Financial services stocks had the highest percentage of negative surprises in the fourth quarter. Current expectations for financial services stocks growth for the first quarter are running at about 60% of that of the overall S&P 500.
  • Info tech disappointments in the Q4 were amongst the lowest frequency of any of the sectors.

There has been wide variance in performance among the sectors this year with financials (at 21.6% of total index) dragging along the bottom at only +0.85% for the YTD. Materials, up almost 12% YTD continue to have very heady expectations.

One other thought. Healthcare generally performs well as the economy slows. Median growth expectations for 2007 and 2008 seem quite robust and perhaps somewhat heroic. However, within this sector, leadership seems to be shifting (finally) to large cap pharma at the expense of small-cap and medical equipment stocks. Large cap pharma growth expectations seem quite low with matching valuations, a potentially potent combination.

Expectations based investing is a useful weapon in attempting to successfully invest using group rotation. Study earnings releases carefully, both of companies in which you have investments and in their competitors. If you have a fix on current expectations, the key is to try to figure out where they are going.  Alfred Rappaport and Michael Mauboussin write in their book, “Expectations Investing,” Like the great hockey player Wayne Gretzky, you can learn to "skate to where the puck is going to be, not where it is." That's expectations investing.


Rick, thanks for your perspectives on the latest 1Q earnings season as well as your take on “expectations investing” (nice analogy with Wayne Gretzky, by the way).  Anyway, without further ado, this author would now like to continue on with the rest of our commentary.  Before we do so, however, let us do an update on the two most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7th at 11,385, giving us a gain of 1,576.98 points

2nd signal entered: Additional 50% long position on September 25th at 11,505 giving us a gain of 1,456.98 points

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from October 1, 2003 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (October 1, 2003 to April 20, 2007) - Over the last week, the big news was that both the Dow Industrials and the Dow Transports managed to close at all-time highs, with the former rising 349.85 points and the latter rising 170.86 points. There is now no doubt that both of these indices are overbought in the short-run (with the former at 8% above its 200 DMA and the latter 11%). However, the internals of the market and most of the world's stock markets continued to remain healthy, and thus the intermediate term trend remains up. For now, we will remain 100% long in our DJIA Timing System, although we will continue to keep watch of any possibility of a *blowoff* to the upside. Readers please stay tuned.

For the week ending April 20, 2007, the Dow Industrials rose a whooping 349.85 points while the Dow Transports rose 170.86 points, as the both of the popular Dow indices made all-time highs.  No doubt, the quarterly contributions from calendar-year DB pension plans that were due on April 16th was supportive for stock market liquidity.  Coupled with the fact that insiders are not allowed to dump shares during earnings season, the recipe for an assault on the all-time highs were firmly in place.  For now, the combination of this and the continued strength in the internals of the stock market (as the A/D lines of the NYSE Common Stocks only Index continue to make all-time highs last week) suggest that we have not seen the top of the stock market just yet – and chances are that we will rise above 13,000 over the next week or so.  For now, we remain 100% long in our DJIA Timing System – and will continue to do so unless evidence suggests that we should trim down our position.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from last week's 19.9% to 22.7% for the week ending April 13, 2007.  Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending April 20, 2007, the four-week MA of the combined Bulls-Bears% Differentials increased from 22.7% to 24.8%. While this reading has been rising relentlessly for the last four weeks, it is still not at a very overbought level yet - and suggests higher stock prices ahread. For now, the intermediate term trend remains up - although we may consider trimming down our bullish position if this spikes higher over the coming weeks.

In last weekend's commentary, I stated: “While the four-week MA of this indicator hit its most pessimistic reading since September 8th of last year on March 23rd, (and is now rebounding) the fact that it isn't bouncing from a more oversold level suggests that any upcoming rally will probably not be too spectacular, there is a very good chance that we will see an all-time high in the Dow Industrials (most probably over 13,000) and possibly an assault by the S&P 500 to the 1,500 level.”  

Now that the Dow Industrials has surpassed its all-time high, what is next?  Well, my guess is that there is still enough “fuel” for the Dow Industrials to surpass the 13,000 level and for the S&P 500 to surpass the 1,500 in the coming weeks.  However, this any upcoming rally be accompanied by a deterioration in the market internals, or should the market simply rise 5% to 10% over the next couple of weeks, then we will definitely trim down our 100% long position in our DJIA Timing System.  If the market continues to merely “climb a wall of worry” (although some will doubt that this is actually occurring), then we will continue to remain 100% long.  Looking at my valuation, technical, and sentiment indicators right now, I simply do not see a significant top developing in the stock market until July or August at the earliest.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market, and it has had a great track record so far according to the following Wall Street Journal article.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from October 28, 2002 to the present:

ISE Sentiment vs. S&P 500 (October 28, 2002 to Present) - The 20 DMA of the ISE Sentiment bottomed at a reading of 98.5 on March 21st (representing the lowest reading since the 97.6 reading on October 30, 2002) and has since bounced back to a reading of 119.9 as of last Friday. Meanwhile, the 50 DMA declined yet again from 112.4 to 112.2, but the 50 DMA seems to be stablizing at current levels and should now be rising as early as this week. A rising 50 DMA has generally been bullish for stock prices - especially after coming off such an oversold reading. Again, this author currently do not see a significant top in the stock market until July/August at the earliest - although we will definitely be open-minded to trimming down our position should the S&P 500 rally 5% to 10% over the next couple of weeks.

As one can see from the above chart, the 20-day moving average of the ISE Sentiment dropped to a reading of 98.5 on March 21st (representing the most oversold reading since a reading of 97.6 at the close on October 30, 2002) and has since bounced back to a reading of 119.9 last Friday.  In the meantime, the 50 DMA declined yet again to 112.2 (a low not seen since October 18, 2006) but is probably in the midst of turning up.  The pessimistic readings coming out of the ISE Sentiment Index suggests pervasive pessimistic sentiment – signaling that the market is definitely a “buy” basis the Dow Industrials or the S&P 500.  Moreover, a rising 50 DMA has usually be accompanied by a rising S&P 500 – and this time should be no different – especially since the 50 DMA is bouncing back from such a highly oversold reading.  However, not everything is perfect at this point – as I am still wary that the average of the AAII, the Investors Intelligence, and the Market Vane surveys did not confirm when the ISE Sentiment became oversold in the latest late February to early March decline.  For now, however, a rising bullish sentiment coming out of an oversold condition is usually very bullish – and thus we will continue to hold our 100% long position in our DJIA Timing System until we see more divergences within the global or the U.S. stock market.

Conclusion: I hope you all enjoyed Rick Konrad's guest commentary.  As for the U.S. stock market, we will continue to remain 100% invested in our DJIA Timing System, as current liquidity levels, valuations, technicals, and breadth suggest that the cyclical bull market still has further to run.   Should the Dow Industrials or the S&P 500 “blow off” 5% to 10% on the upside over the next couple of weeks – accompanied by deteriorating market internals, we will definitely trim down on our 100% long position in our DJIA Timing System – but as of Sunday evening, we will remain 100% long.  We will continue to reevaluate our position in our DJIA Timing System, and will send out a real-time email alert to our subscribers should we decide to trim our long position in our DJIA Timing System.  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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