I spent most of the week doing a lot of market research and thinking about the current move and what we have to look forward to next. It’s important to stop and smell the roses when the market is on a roll, but I think it’s critical to watch out for the thorns and bees that might be hanging around. When looking at the bigger picture and trying to see what comes next, I focus on probabilities, percentages and outcomes and wrap it all up with a theme called “Expected Value.”

I apply Expected Value to my overall assessment of what we face every day in the market. What is our current state? What is the probability it will continue and what is the payoff for that continuation? Then I look at all the other possible scenarios, their probabilities and their outcomes. The net result of all this is a rough guess of the upside or downside. I do this for geopolitics, earnings, fundamental valuations, technical analysis, economics via treasury rates, oil, currencies, and commodity prices. I typically do this one day out of the month and focus on my expectations for the next 30 days. It’s limited, it’s “subjective analytics”, it’s pretty short term and it usually turns out pretty correct. So look back at this post a month from now and see how I did.

Earnings - the next scheduled event on the calendar is the earnings season that’s just around the corner. Last quarter, earnings were overshadowed by other events such as Israeal / Hezbollah and the August FOMC rate decision. This time around, earnings season is the primary focus. So far, negative vs. positive pre-announcements has been worse than usual but most of that has come from consumer discretionary (not a surprise). I just don’t see the 14% earnings growth that Thomson is expecting. When we are facing a moderate to low GDP growth, I struggle with the mismatch with expected earnings. This past week, executives were relatively negative about corporate outlooks, but everyone either ignored it or just downplayed it in light of the Dow’s record highs. I took it as a hint that things may not be as great as expected. Even more importantly, I have concerns about guidance. Summary: The current state of earnings is very good, but I think there is a high probability that it will not be good enough or even disappointing, especially forward outlooks.

Geopolitics - We have benefited from relative calm since August. Israel is out of Lebanon, Iraq is somewhat worse, Afghanistan is definitely worse but no one seems to notice, no significant terrorist activity, etc. etc. However, despite Iran and North Korea being in the shadows for a few months, that appears to be coming to an end. US politics has degraded into its usual pre-election mess, and it is not good for the markets no matter the spin. Summary: The current state of geopolitics is good, but I think there is a very high probability that tensions with Iran and North Korea will shake up the market.

Fundamental Valuations - With the S&P 500 PE hovering around 17, it’s reasonable to say that valuations are not out of control. In fact, they have been pretty reasonable and don’t give me much concern. However, I doubt that they will get much lower and to me, the most likely case is an S&P 500 PE that will likely stay between 16-17 as a normal range for some time to come. Summary: The current state of market fundamentals are good, and even if the earnings scenario I mentioned above leads to higher valuations, I don’t expect them to be a cause for selling.

Technical Analysis - Market technicals are strong and yet, we are due for a correction. I have no idea when things will start to slide, and until that happens, I will remain bullish. As I have written in recent posts, I am getting less comfortable with a positive view. Summary: The current state of market technicals are very good and I think there is a good probability they will start to weaken.

Economics - I think we have squeezed as much as possible from the Goldilocks scenario and rates (as reflected in the 10-year) are about as low as they will go. The slight inversion of the yield curve is concerning but like the rest of the equity market, I am still not overly convinced that a recession is a must - just a “maybe”. With each conflicting economic report, it looks like we will stay in no-man’s land. Summary: The current state of the economy is decent, and unless we get a clear indication of economic contraction, I expect rates to increase from here, especially the 10-year.

Oil - The oil market was trying to find support on its own around $60 but now that OPEC is hinting at pulling some supply, it looks like there will be less of an effort to sell oil. In fact, we might even get some of those nasty speculators to accumulate some long positions. Summary: The current state of oil (and by default, gasoline) has been beneficial to the consumer during the 30% decline in gas prices, but I expect the declines to level off, if not start a reversal higher.

Currencies - Since Secretary Paulson showed up, the dollar is strengthening and yet, I am a bit concerned about the relative growth rates in the US vs. China as well as the gap between European and US interest rates. Summary: The current state of currencies relative to the dollar are not affecting US equities and I don’t expect anything dramatic enough to change that.

Commodity Prices - The slide in commodites since May has been more than a healthy pullback, it was painful for the longs. It’s tough to look at commodities as a single item because some (like copper) were more bubblicious than others.  Overall, I don’t think the long term bullish move is over. Summary: The current state of commodities declining has been bullish for equities, but I think there is a very high probability that the CRB will rise very soon.

Overall, many of the factors I look at when thinking about the market have been conducive to higher equity prices. However, what concerns me is that I don’t see them getting much better than they already are and in my opinion, several of them look like they are doing more than just leveling off - they are reversing. From an Expected Value perspective, the probabilities of negative outcomes outweigh the combined probabilities of maintaining our current state or heading towards more positive settings. I expect equities to battle with average earnings and guidance, geopolitical stress, weakening technicals, higher treasury rates (10-year), higher oil, and generally higher commodities in the coming month.