1Q07 Earnings Outlook and Implications

Since last summer, there has been a sharp deterioration in earnings expectations for every economic sector for 1Q07 and the full year. Granted, analyst earnings expectations tend adjust downward as optimism fades and reality kicks in. Nevertheless, the downward adjustment, as noted on the following tables (page 2 of this report - see left side "services" link), is a rather large one, particularly considering the fact that all of the decline has taken place while stocks were making new highs.

If one steps back and recalls the logic behind the rally - soft landing mission accomplished, recovery mode in gear -, then the slide to low single digit land for 1Q07 and mid single digits for 2007 (and who is to say that number won’t be adjusted downward?) should suggest that all is not well in marketville.

Then there is the issue of correlations.

The right hand column of Table 1 (see report) is from Rich Bernstein at Merrill. And what it shows is rather striking. In just under one year, the homogenization of market performance is very apparent. Correlations of eight out of ten sectors show a rise, in many cases a very sharp rise. This data helps explain the synchronization of sectors that the markets experienced over the past 9 months. Specifically, in 2006 and now into 2007, sectors have risen, fallen, rose again, then fallen again, in near unanimity. What this suggests to me is that hedge funds, and increasingly mutual funds, are under greater and greater pressure to perform – even in the very short term.

Moreover, when one considers the explosion of hedge funds (in number and dollars under management), an investor has to wonder just how many great ideas and great 20 year-old fund managers are out there? It is, therefore, logical to conclude that my oft-stated comment re the pressure to perform is compelling the more short-term oriented players in this group to chase every twist and turn and dive into and out of sectors, industries, styles, and countries en mass.

Investment Strategy Implications

In the coming weeks, the market stage will be a shared one. Macro factors, such as sub prime loans (and the not fully appreciated link to credit default derivatives), will share the stage with earnings season. And tomorrow’s Goldman Sachs report will likely set the early tone.

With a 6.8% slide in 1Q07 S&P 500 earnings from last August to the present, I suspect the surprise may be to the downside. And that fact could easily be the major catalyst for the second wave of the correction, as both bring into question the bull case.