Sentiment: The Market will Never Fall

July 22, 2013, 11:03 am ET, BY Thomas H. Kee Jr- Editor, Stock Traders Daily| Editor: Thomas H. Kee Jr. (Follow on LinkedIn)

That is the sentiment on Wall Street, at least for the time being.  This giddy and blindly bullish sentiment often riddles the media through guest appearances after equities get influenced higher by the smaller investor.  This is exactly what has happened during the Great rotation, and it is exactly what often identifies major market peaks.

Once they get the little guys to chase the market, Smart Money usually watches for the right time, and then starts selling into the rally.  When International Business Machines Corp. (NYSE:IBM) and General Electric Company (NYSE:GE) surge the day earnings are released, even though the companies actually reported lower revenues and forward projections were not increased, we have evidence of a giddy market driven by investors who are reacting to the news instead of paying attention to valuation. 

Eventually this will change, and the writing is on the Wall.

Furthermore, investors are currently balking at any market decline, almost worried, but these vocal investors very well may be the same investors who rotated out of bond funds and into the stock market recently as well.  They took losses on their bond fund investments, their brokers told them that they could get growth and income by investing in the Stock Market, and without paying attention to valuation they followed, driving equity prices higher than they should be given reasonable growth expectations.

Last week I recorded a Webinar that identifies the fair value of the S&P given earnings growth expectations, and by every measure analysts are extremely optimistic about the next year, but they were forced to bring down their optimistic estimates for the current quarter by 10% from where those were a year ago as well.  Current valuations are lofty, with trailing as-reported P/E for the S&P 500 now over 19.  I expect that to adjust down to an 18x handle after this season, but there is one big catalyst.

Apple Inc. (NASDAQ:AAPL) is expected to release earnings after the bell on Tuesday, and that will play a significant role, but roughly 25% of S&P companies will report earnings this week, and that combination will likely give analysts enough information to make the forward adjustments necessary to bring their current estimates in line with fair and reasonable growth, at least for next quarter.

Obviously, given what we currently know, analysts are expecting extraordinary EPS growth next quarter, but these expectations were lofty to begin with, and the headwinds that we know of are only now starting to hit this economy.  Although I have not found any quantifiable relationship between reported GDP growth and earnings, I have found an almost exact relationship between the consumption expenditures component and earnings since 2011.

Indeed it was in 2011 that earnings comps began to come down, and in my opinion future comps are much more difficult, but the Street actually believes that future growth rates will show EPS growth equivalent to those that existed when comps were extremely easy (right after the recession).  I am warning everyone that is not likely reasonable.

Smart money is selling into this rally, and soon those same weak handed investors who were chasing performance as they transitioned out of bond funds and into equities, those same investors who likely drove up the iShares Russell 2000 Index (ETF) (NYSEARCA:IWM), are likely to be the ones fueling the selling when the tides actually turn.  Smaller investors have a natural attraction to smaller companies, and we all know what has happened to the Russell since the Great Rotation began.  Right now no one expects any decline from this market, that is obvious, but tides turn fast.

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