Making Sense of Stocks
Investment advisors spend a lot of time thinking about the future of the markets. I give people my opinions, I hear theirs, and I'm a total news junkie on the subject.The more I talk with individual investors, the more I realize how easy it is for people to get sucked into one of two opposite extremes when trying to make investing decisions.Extreme Position #1Daytrader data analytics approach: Gather all available data and develop an algorithm to predict the day and time that a stock will go up or down. Buy and sell accordingly. Try to figure out how to time the market on a weekly, daily, or hourly basis.Extreme Position #2Superstition + gut feeling approach: Gather no data but rely on a sneaking suspicion that if yesterday was good, tomorrow will be bad. The market was up in 2017, so the only direction it could possibly go in 2018 is down.I don't recommend either of these strategies. Your gut is not a rational analyst. And even if you have all the data in the world, don't try to time the markets.That said, there are plenty of good tools investors can use to make good, informed decisions. Today I’ll show you three charts I use to track the pulse of the market. All three focus on corporate earnings.
Corporate Earnings: Past, Present & Future
Over the long run, earnings drive stock prices. The chart below shows earnings actually generated by the companies in the S&P 500 from 1991-2016 (solid black line), with the black squares in the upper-right corner showing estimates of future earnings from year-end 2017 through 2019:
Stock prices tend to follow the direction of earnings. Are earnings going up, down or sideways? Is there any reason to think their direction will change dramatically? These are the questions I ask myself every day.Forecasting earnings in the short term is difficult. Forecasting earnings in the long term is easier. The long-term trend has followed a +7.4% growth path since 1991, though it hasn’t been a smooth ride. The U.S. economy and its businesses tend to grow over time, so if you have confidence in the U.S. economy, it’s reasonable to think earnings could continue to increase.In addition to showing earnings, the chart below overlays the price of the S&P 500 index (the green line). I’ve also added two little green boxes with red question marks. Thanks to the new tax bill, there’s good reason to think corporate earnings will be higher in 2018 and 2019 than previously projected. If earnings do increase, the green line should move up as well, though not necessarily at 2017’s frantic pace.
Finally, I keep an eye on the price-to-earnings ratio and inflation rates.The third chart shows that since 1960, stocks have traded at an average price of 19.2 times trailing earnings. As of the end of December 2017, the stock market traded at a P/E ratio of about 20.5x, which is not too far off the long-term average. When the P/E ratio is well below its average, it’s typically a buy signal, and when it’s well above average, it’s typically a sell signal. Today it’s neither, but at some point that will change.
As useful as they are, these charts will never give the perfect answer. It is simply impossible to know how stocks will perform in the future. But understanding the relationship between earnings and prices will be a skill you can put to good use for as long as you invest in stocks.