So Much for the 'New Normal'
As tax season winds to a close, the new focus of investors shifts to earnings season. After bottoming in 2009, corporate earnings have seen substantial improvement over the past two years - more so, even, than stock prices.
Now more and more researchers (some of whom missed the recovery for their clients, some who didn't) are forecasting even further increases in corporate earnings. In fact, the growing consensus among many large investment houses is that by August of this year, the 12-month earnings for companies listed in the S&P 500 will reach an all-time high, even when adjusted for inflation.
First let's start off by saying bon voyage to Bill Gross' "new normal". Unfortunately for the venerable PIMCO founder and many other pundits, their thoughts on the 2008 crisis that "this time is different" proved to be slightly less than accurate.
But back to earnings: Back in March of 2009, the S&P 500 had a price to earnings ratio of roughly 100 (depending on the numbers used). Without any other information, that little tidbit would have been a major sell signal for more than a few investors. Unfortunately for those who followed this signal (and many did), they were selling right at the bottom of the market.
What investors really need to understand about prices and earnings is that there are two sides to the equation; and either can push the ratio to one extreme or another. For example, it's true that a price/earnings ratio can be high because of irrationally high prices; but it could also be due to unusually low earnings. Conversely, P/E may very well be low because of depressed prices, but it might also be caused by unsustainably high corporate earnings.
While these might seem like simple technicalities, they have serious implications that are often over-looked, especially by so-called black-box trading systems.
Admittedly, one of the phrases commonly floated around our office is that "different opinions make a market," but this case is a fantastic example of why it's important, when investing, not to drive by watching the rearview mirror.
Instead, it's imperative that investors maintain a broad picture view of the economy and a firm grasp of the fundamentals of the market in which their operating.
Recently many investors, both clients and non-clients, have inquired whether we expect the stock market's rally can continue. Many are skeptical, as the bull market in stocks has run for over two years almost without interruption, and the market now seems priced more appropriately for earnings - a P/E in the mid-teens is a reasonable long-term average for stocks on the whole.
However, what many of our inquisitors fail to realize is that their question, at its core, has almost nothing to do with stocks. What they're really asking is an economic question, and that is whether we expect continued growth in corporate earnings.
After all, this is the basis for the stock market: investors pay for a portion of a company's future earnings (dividends).
These are the kinds of questions which we are constantly asking ourselves. In an attempt to answer them, we are constantly conducting research and watching various factors develop in different sectors of the economy, each of which will give us clues as to what is coming next for the economy. Will earnings growth continue? Is money supply about to explode? Will rising oil prices hinder further economic growth?
All of these questions have implications in the investment world; and they ought to be at least considered by all investors in their decision-making process. Our own investigations, along with our conclusions - which, by the way, are almost constantly changing as circumstances develop - and our methods of applying those conclusions are why our clients pay us.