Citi Research analysts Tobias M Levkovich, Lorraine M Schmitt and Christina Wood look at stock prices in the context of the real quality of recently reported earnings, earnings guidance and a liquidity-based rally, and sound worried in their report “Unsettling Disconnects” of October 25.

LMNOP = “Liquidity, Momentum, Not Operating Performance”

Citi observes that with the ‘tapering’ threat now in cold storage, and the debt ceiling issues kicked down the road, investors are trading markets higher based on momentum and liquidity factors. Short covering and year-end alpha/benchmark targets may also be adding fuel to the fire. The acronym ‘LMNOP’, according to Citi, aptly describes the current state of the markets.

Earnings – looking under the rock

Worryingly, investors appear to be unduly focused on headline reporting of earnings and are carrying an impression that businesses are managing wonderfully. The reality is very different, according to Citi.

–  The ratio of companies beating estimates (currently ~70%) is trending lower than in previous quarters as per this chart:

Earnings

– The overall quality of results is low, considering that a significant number of companies have reported ‘beats’ based on lower-than-expected tax rates, low interest outgo or via once-off, below-the-line credits. This suggests that the beats emerged from financially convenient factors, rather than true operational business improvements. It is therefore not true that EBIT margins have improved, as per these charts:

2-true-margins

Guidance down, stocks up?

Another issue that bothers Citi is the disconnect between stock prices (which maintain an upward bias) and 2014 guidance trends (a knob that companies are turning down), as per the chart below. Given the close correlation between EPS and stock prices, this divergence is disconcerting.

3-guidance-vs-stock-prices

The danger of trading seasonality

Citi analysts caution that the market is already up 20% and investors may be caught on the wrong foot if they “chase the tape” based on greed, assumptions of seasonality and momentum trading. September, a lean month based on seasonality, was turned on its head this year, and a similar, unexpected outcome could well occur with respect to the usual year-end bullish trend.

Cyclical Expectations Model – a fundamental, and rare, divergence

Citi’s Cyclical Expectations Model captures retail sales, freight, commodity prices and bond market spreads and this model has diverged significantly compared to the S&P 500 (INDEXSP:.INX):

4-cyclical-exp-model

This shows that stock prices may have surged ahead of fundamentals, and may be trading up instead due to liquidity and momentum drivers.

Citi concludes that investors may be unduly complacent and they could face disappointments in the near term.