Investing is not an exact science.
Its why there’s no formula or process that will guarantee returns 100% of the time. There are, however, key factors that will determine the price of a stock over time. The most important is earnings power.
If a business can grow earnings without using too much debt, the stock will probably rise. It’s why so many investors focus solely on earnings.
The trouble then is how can you predict future earnings? All we have is past financial figures. How can we use the past to predict the future?
Answer is we can’t. Not with 100% accuracy anyway. But investors still pay through the nose for analyst projections and forecasts.
For their fee, analysts go away and create huge spreadsheets. Baked into these spreadsheets are various assumptions and key ideas.
But what comes out is more or less similar to the recent past. Meaning analysts generally believe recent past performance will continue.
Of course such ‘expert research’ doesn’t always work out.
Don’t trust the estimates
It’s impossible to know, to the last cent, how much a company will make year-to-year. Analysts know this. They don’t believe they’re some oracle that knows everything that will happen.
But with all their experience and education, maybe they can get close to this figure, right? Well, not really.
More often than not, analysts focus far too much on the recent past. For example, almost no analysts revised their estimates down just before the 2007–09 financial meltdown. Surely these expert researchers would’ve foreseen something so dramatic?
Yet it turned out, like everyone else, they had no clue. Take a look at the graph below. It shows earnings per share (EPS) estimates and actual figures of the All Ordinaries from 2005 to 2017.
[Click to enlarge]
From 2007–10, EPS ripped down, without analysts ever sounding the alarms. Even more interesting is the yellow line. It represents forecasting error, or the estimate vs actual on a percentage basis.
If this line is above 1, it means that EPS estimates were above what actually happened. If you were to follow this information as an investor, you’d probably lose a lot of money.
On the other hand if this line was below 1, it means estimates were far more conservative than actual figures. Such information would make investors rich.
As you can see, the yellow line rarely dips below 1.
If that doesn’t say analysts are generally always bullish, I don’t know what does. You’ve probably noticed, analysts along with investors have been bullish for years now.
But that is about to stop right now…
2018 is the year…
Yesterday, most investors were happy.
A potential trade war seemed to be off the cars. Everyone was happy with Mark Zuckerberg’s response to the US congress.
US stocks are now up more than 3% since Monday last week.
And of course positivity has spilled over into our market as well. Will we look back on early 2018 and see it as a temporary speed bump?
Since the lows of 2009, our market has gone on a tear. The All Ords is up 89% without a major upset (a 12-month fall of 20% or more). The 500 largest US stocks have done the same. The S&P 500 has gone straight up 281%.
But that long run could soon come to an end. Maybe it already has. And there is more than one reason why 2018 will be the year the bull run stops.
First let’s look at interest rates. They are an important factor when valuing any asset. It has to do with how central banks increase interest rates.
First they increase the rate at which they lend to financial institutions. These institutions then just push higher interest rates onto their customers, thus decreasing demand for credit.
Second, they venture into the bond market and start selling like crazy. Think of a bond like a stock which pays out fixed dividend for a fixed time period.
If the price of that stock goes down, the dividend yield increases. The same applies to bonds. As central bankers sell down bonds, prices fall and yields rise. And because you know these payments are fixed, this yield is essentially guaranteed.
You’re likely aware the US Federal Reserve is intent on increasing interest rates. Higher rates don’t just mean less money in the system. It also gives the Fed ammunition in case the economy takes another turn for the worse.
*Spoiler: and it will at some point.
The Fed also wants to put a quick cap on inflation. Imagine if the price of goods started growing at a much faster rate. To phrase it another way, imagine if your cash started to devaluate more rapidly than 2% annually.
If wages don’t significantly grow, a lot of wealth will be destroyed.
The second factor putting a strain on this market is valuations. Various multiples like price-to-earnings, price-to-sales and price-to-book are very high.
But more importantly, if the ‘risk free rate’ rises, there will be little incentive for the ‘big money’ to stay in stocks. Remember bond yields. AAA government bond yields are basically risk free investments.
Whatever yield you buy them for, that’s the yield you’ll get over the life of the bond. So if this yield rises from 2.9% to 4%, billions of dollars will be asking the tough question of whether or not to stay in stocks.
The third factor is what we discussed at the start of this article — over optimistic forecasts. Right now, earnings estimates are near record highs, for the US at least.
This is not to say earnings won’t grow. I could be proven wrong and pleasantly surprised by higher earnings. But optimistic forecasts leave a lot of room for disappointment.
We’re now looking at a market jumping at anything. But I suspect we’re in for more volatility ahead, rather than a straight up market we’ve seen in the past nine years.
Editor, Money Morning