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The stock market optimists are about to be crushed

Stock markets are still pricing in a strong recovery. But the bond markets are painting a much gloomier picture. And if they're right, then the slightest setback could send stocks tumbling at any moment. David Stevenson explains why.

Yesterday was another decent day for the markets. The FTSE 100 closed 64 points better. And on Wall Street the S&P 500 was up 0.5%.

So what caused all the jollity?

Nothing much. The Bank of England kept base rates at 0.5% no surprise there. And US initial jobless claims fell more than expected, although the recent average is still higher than earlier this year.

But this apparent calm is masking the big problem that the world's stock markets, led by the US, are now facing. Bond yields and share prices are painting very different pictures.

And with vast bullishness already baked into US stock prices, any knocks to confidence could send shares diving any day now...

It's a bit of a puzzle.

US and UK government bond yields are flirting with record lows, which is seen as a sign of a fast-approaching economic 'double dip'. Yet analysts' forecasts for company profits are currently climbing.

This isn't how it's supposed to work. As economic growth evaporates, the return on business assets falls. In turn, that makes the fixed rate of interest paid by government bonds more attractive. So investors pile into them, which pushes up prices and lowers yields. That's now happening in government bonds.

The flip side is that as demand drops for their products, companies suffer profit dips. Lower earnings equal higher p/e ratios, making shares pricier and less appealing. So many shareholders sell, and stock markets then fall.

But right now, this last bit isn't going according to the script. Global share prices driven by the US are still going up on expectations of higher profits to come.

Why are global share prices rising?

What's fuelling these hopes? Let's take a peek at the profit estimates that US research analysts have been churning out.

In the States, Standard & Poor's makes this a (relatively) easy exercise. That's because S&P adds up all the forecasts made on individual stocks to give an overall quarterly earnings figure for the S&P 500 index. It publishes the data on its website.

Here's what the latest picture looks like

10-09-01-MM01a

The blue line shows how quarterly operating earnings for the companies in the S&P 500 index have grown since 1995. The price of the index itself is shown by the black line, which has been rebased to the same start point.

In 2006 and 2007, earnings were boosted by vast profits in the banking sector. Then the Great Recession hit hard. It clobbered returns right across the board. In particular, the banks stacked up such huge losses that they needed massive state bailouts. Operating earnings on the S&P 500 index dived to zero.

Partly due to these bailouts, earnings have shot back up again in the banking sector, as you can see from the chart (although to my mind, some of the profit gains are a bit dodgy, as I explained a few weeks ago: The US banking recovery is a sham).

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But here's the truly scary bit the red line. This shows the total of analysts' estimates for S&P 500 stocks over the rest of this year and for the whole of 2011.

As you can see, Wall Street's finest now expect S&P 500 index earnings to rise above their previous credit-bubble era peak. And this is at the same time as the bond market is telling us that the double dip is about to hit!

Clearly, something is way out of whack here. And that can't continue for much longer. US share prices are where they are today only because of these earnings expectations. If it becomes clear that they are overly optimistic, then the current air of confidence will be shattered.

The market's deluded

So far, US companies have managed to jack up their profits by slashing costs. But while operating earnings have rebounded to their current levels from that end-2008 'zero', sales have hardly grown at all. In fact, says S&P, by the first quarter of this year, they had expanded by less than 1%.

And there's a limit to what you can do with cost cutting. If corporate America is going to keep raising its profits, it has to kick-start top-line growth i.e. sales have to start growing. But if the double dip forecast by the bond market arrives, that's hardly likely to happen. In fact, sales are more likely to drop, while costs rise. That realisation would hammer share prices.

"The current situation reminds me of mid-2007", says Albert Edwards of Socit Gnrale. "Investors then were content to stick their heads into very deep sand and ignore the Great Unwind that had begun. Even though the wheels were clearly falling off the global economy, the S&P still managed to rally 15%! Recent reaction to data suggests the market's in a similar deluded state of mind."

Indeed, unit labour costs which must keep falling for earnings to increase have already started climbing.

"With [profit] margins so high, any slowdown will crush productivity growth. Whole economy profits are set for a 2007-like squeeze", says Edwards. "A sharp slide in analysts' optimism confirms we're right on the cusp of falling forward earnings. Equities typically don't begin to slump until just after analysts begin to cut their 12-month forward earnings estimates."

Protect your portfolio from a major sell-off

In short, we could be on the verge of a major sell-off. We've said this several times before, but to protect your portfolio as much as possible, it's a time to hold cheap defensive shares with good yields. That applies globally. But this also looks a good moment to sell any US stocks that have reached your target price.

For example, in January we tipped Time Warner Cable (NYSE: TWC) at $42, with a $55 target. Yesterday the stock reached that level. If you bought then, now's a good time to be disciplined and take your 30% profit.

Our recommended article for today

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