Price is a vote on the future. Earnings are the receipt for the present. The two have always argued, drifted apart for a quarter or two, and then found each other again. What makes the current market unusual is not that a gap exists. It is how long it has stayed open, and how comfortable everyone has become living inside it.

What the gap actually looks like

Any market return can be split into three parts: the income you were paid, the growth in the businesses underneath, and the change in what buyers are willing to pay per unit of that growth. The third part is sentiment wearing a mathematical costume. Across long periods it contributes close to nothing. Across the recent past it has done a great deal of the work.

That is the first thing worth tracking, and it requires no forecast. When most of a market return comes from the multiple rather than from the earnings, the market has not become more productive. It has become more expensive. Those are very different conditions with very different consequences, and they look identical on a chart.

Why expectations rise exactly when they should fall

Investor surveys keep finding the same shape. Expectations of future returns go up after a strong period and down after a weak one. This is precisely inverted. A higher price today, attached to the same stream of cash, mathematically means a lower return from here. The better the recent past, the worse the arithmetic for the future.

Three forces keep the inversion alive.

• Recency. The most available evidence about the future is the recent past, and it is weighted far beyond what it deserves. Two good years feel like information. They are mostly just the two most recent years.
• Price insensitive buying. A large and growing share of flow arrives on a schedule rather than on a judgement. Money enters on payday and is allocated by rule, with no view on value at all. This is sensible behaviour for the individual and it means the marginal buyer is not checking the price.
• Social proof. Positions are now held in public, in real time, in front of an audience. A feedback loop that used to run between an investor and their statement now runs between an investor and a crowd, and crowds are not good at valuation.

Unnatural is not the same as irrational

It is tempting to read all this as a market gone mad, or worse, as a market being manipulated. Neither fits. Every participant in the chain is behaving sensibly given the rules they face. The saver contributing monthly is doing the right thing. The index fund buying without an opinion on price is doing exactly what it promised. The manager who tracks a benchmark rather than departing from it is protecting a business that would not survive two years of underperformance.

Sensible individual behaviour is producing a collective outcome nobody chose. That distinction matters because it tells you what to do with the conclusion. You do not need to predict a collapse, and predicting one has been an expensive hobby. You need to stop assuming that whatever produced the last several years of returns is the thing that will produce the next several.

Four numbers worth watching

• Earnings revision breadth. The proportion of companies whose forecasts are being raised rather than cut. It tells you whether the fundamental picture is broadening or narrowing, independently of what the index is doing.
• Free cash flow conversion. How much of reported profit actually arrives as cash. A widening gap between the two is one of the more reliable early warnings available.
• Index against equal weight. When a capitalisation weighted index pulls far ahead of its equal weighted version, the market return is coming from a handful of names and the diversification is cosmetic.
• The premium over cash. What you are being paid, in prospective terms, for owning equities rather than short dated instruments. When that premium compresses toward nothing, the compensation for the risk has gone even if the price keeps rising.

None of these predict a turn. All of them tell you what kind of market you are standing in, which is a more useful thing to know and a far more achievable one.

What we do with it

FinAI was built to keep the two stories apart: what the price is doing, and what the business is doing. Run over a portfolio, it reports how much of the current position value rests on earnings and how much rests on the multiple.

The platform does not tell a client the market is wrong. It tells them which part of their return is currently being supplied by sentiment, because that is the part that can be withdrawn without notice and the part that rarely appears in anyone expectations.

This article is general market commentary from AsquareC FinTech FZCO. It is not investment advice and does not take account of your circumstances.