Downside Risk Dwarfs Upside Reward

Gold Alliance disclaimer

Written by Lance Roberts via Real Investment Advice

I recently received the following email: “Are we going to hit new highs you think, or is this a setup for the real correction?”

The answer is “yes” to both parts.

Thank you for reading. See you next week.

You still here?

Fine, let me explain then.

Price and Expectations

The “price” of the financial markets is ultimately driven by one thing and one thing only: “expectations.”

Yes, fundamentals, valuations, interest rates, etc. all play an important role, but it is ultimately “expectations” of “the herd” which moves prices. Currently, valuations on stocks are at the second-highest level on record, but “expectations” are that a continued “low-interest-rate environment” can support economic growth allowing stocks to “grow” into their valuations.

This is why Wall Street begin using “forward operating earnings,” which are complete nonsense, to justify high valuations and, you guessed it, “expectations.” (Operating earnings are essentially “made up” earnings without any of the “bad stuff” included.)

For more on this valuation read a recent article we wrote on the topic titled Price to Forecasted Hope.

Meeting those Expectations

The problem, historically speaking, is when those “expectations” are disappointing as shown below.  There are three important things worth pointing out:

  1. The top panel is GAAP earnings (what companies REALLY earn) and nominal GDP.
  2. The black vertical line is when the markets begin to “sniff out” something is not quite right.
  3. The red bars are when “expectations” are disappointed.

While “expectations” were indeed disappointing in 2015-2016, the long-term rising trend line was never violated. Secondly, the current warning signal (black vertical line) is in place, but “expectations” have not yet been disappointed.

As I discussed yesterday, one of the biggest problems facing investors is that many have never recovered from the previous two bear markets. While “this time may seem different,” the reality is such is probably not the case.

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