Stocks have had an incredible run so far since the beginning of the year. The S&P 500 is up a whopping 6.7% during the period, closing at 1342 on Friday.
Why were they so conservative?
Well, some of the key risks cited included deterioration in the eurozone debt crisis, turmoil in the US political system, and slowing in the Chinese economy. All of which ultimately threatened corporate earnings, which is the key driver of stocks.
Here’s the thing: earnings growth expectations have come down sharply. According to FactSet data, year-over-year earnings growth expectations for Q1 2012 have plummeted from 8.0 per cent on September 30, all the way down to 0.0 per cent this week.
Meanwhile, stocks roared ahead during that same period (See the chart below). This has the bears going nuts.
Have investors gone completely crazy? Maybe. As the saying goes, ‘markets can remain irrational longer than you and I can remain solvent.’ Credit Suisse’s Andrew Garthwaite has written about numerous anomalies occurring in the global financial markets.
There is, however, one explanation for this bizarre disconnect between stocks and earnings expectations: valuation. Indeed, low valuations was one of the key reasons why BlackRock’s Larry Fink recommended being 100 per cent invested in stocks.
Soaring stock prices (numerator) amid falling earnings growth expectations (denominator) is a very quick way for valuations to rise back to historical norms.
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