The Stock Market, The Business Cycle, and Earnings

September 2, 2011 Leave a comment

The stock market isn’t a random set of numbers that goes up and down for no reason – although it seems like that’s often true.  No, the stock market is tied to company earnings, and earnings are in turn tied to the business cycle.  The connection is a loose one, with plenty of play both on the upside and the downside.  But the link is real and permanent.  The stock market will always return to fair value after straying too far afield, and fair value is determined by current and future earnings.

One of the best sources of information for all things related to earnings is Zacks Investment Research.  Below is an article from Zacks.com which I think does a very good job of highlighting the link between earnings and the market.  The author is Kevin Cook, who has written extensively on the market and earnings.

“While you enjoy your Labor Day weekend, and think about White House plans to give more people labor afterwards, you will have something else to look forward to when you get back to work and investing next week: earnings estimate revisions.

But many of these will not be of the happy kind. They will be downward revisions.

Below is how I summed it up on August 3 in “Look Out Below!” when the S&P 500 had punctured the June lows at 1,260 and I said “Next Downside Target: 1,200.”

“The next target will be somewhere in the 1,200 to 1,175 area. This is a highly likely scenario because the focus has shifted from exceptional earnings to questions about where the growth will come from to sustain them.

What you don’t see yet in the earnings picture is the downward revisions and warnings that will likely come after Labor Day in preparation for third quarter earnings season. Remember, equity portfolio managers have to look out at least two quarters to model their risk/reward.

PM’s listen to equity analysts because analysts have their ears to the ground on companies and industries. But analysts haven’t yet begun to lower their future earnings estimates.

In their line of work, they have the luxury of time on their side because it is far better to have lots of confirming data from the economy and from the companies themselves before lowering estimates than it is to be early and wrong.

So some PM’s will shift their asset allocations and, if in doubt about earnings and estimates, they will lighten their holdings of higher-beta growth names. Then when the lower estimates do roll in, the selling will really heat up.

Whether or not the economy actually logs another dip into recession territory, equities will be part of a self-reinforcing feedback loop that prices in much slower growth.

Why? Because Emerging Markets cannot get much hotter right now. And there is nothing in the data to suggest that domestic demand is going to pick up from here, especially as unemployment trends stagnant to higher.”

GDP vs. Corporate Earnings Disconnect

It was a big deal for me to get so bearish so quickly in early August. Why? Because even though I had grown cautious in May and went to over 50% cash in my personal portfolio, I was still bullish on global growth, especially from the double-digit engines we call Emerging Markets (EM).

It was wonderful to enjoy the unfolding record-breaking success story of the S&P 500 on its way to earning nearly $100 per share in 2011 and over $105 in 2012. But those July 29 GDP revisions which took first half growth down to 0.85% made me question all my assumptions.

Here’s what I said on August 2 in “Jobs, Growth, and Stocks: Perilous Company”…

“But, now that I think the catalysts — primarily sovereign debt crises vs. EM growth — are becoming less balanced, my view is shifting even more towards the “lower” part of the equation (based on my May 31 call for a ‘sideways-to-lower’ summer stock market).

Why? Because of the ‘structural economic internals.’ What I mean by that mouthful is that if EM is slowing down and GDP and jobs are weak, the economy cannot support the stock market at these levels. The earnings won’t be there in the next quarters.

On August 3, I’ll look at the chart of the S&P 500 and why a break of the 200-day moving average could finally take us down to 1,200, and probably much lower. I will also look at the dollar as a ‘scorecard and symptom’ of risk appetite that could confirm lower equity prices.”

So now that we have priced-in a mild potential recession, is it still possible that global growth from Emerging Markets could save the US economy from a worse contraction? Yes, it’s possible.

But the probability is pretty close to a coin flip when you look at the combination of weak US cyclical data and the engineered slowdowns occurring in “engines” like China.

And remember, the trend and momentum of the business cycle are a “big ship” that turns slowly. Corporate profits are inextricably tied to that cycle. Yes, many companies will still do well even in a slow-growth, 1%-GDP, muddle-through environment.

But, the negative feedback loop in an economic contraction is a falling tide that takes most stocks down with it.

As of August 31, the Standard and Poor’s website has the next four quarters of earnings estimates totaling $105. At an index level of 1,200, that’s a forward P/E multiple of 11.4. At S&P 1,100, it’s 10.5. Those are very cheap market valuations — as long as estimates and growth aren’t headed lower.

Even if I don’t and can’t know how bad things could get, as I said in my “Gray Skies” article earlier this week, I will be buying stocks at S&P 1,100 and lower when we go back down there.

See my “Recession Watch” articles linked below for bearish scenarios and possible government action to thwart them.

A Moving Puzzle

Markets are both a puzzle and a moving target. I have learned over the years to focus on “why the big money moves” into or out of stocks to help tell me what the next trend is.

Years ago, my knowledge was a hodgepodge of ideas about the economic cycle and “institutional money flow.” Last year, I reformulated that into clearer ideas about how the “outperformance” mandate of portfolio managers created certain rules for the game that made them “have to buy” stocks.

I wrote a series for The Options News Network in January 2010 titled “5 Secrets of Wall Street: Profiting from How Stuff Works.” Two of the “secrets” were “They Have to Buy Stocks” and “They Don’t Have to Sell.” (I will share more about these ideas in a future piece.)

Then when I discovered the Zacks model only early this year, I further refined my approach to focus more specifically on earnings momentum and analyst earnings estimate revisions (EER).

Needless to say, 2009 through 2011 has been my best stretch for market timing. But I don’t always tell the story that well when given my opportunity in a 30-second “elevator speech.” Like yesterday when I was on FOX Business in the closing hour with Cheryl Casone and two other guests.

One of them said that stocks would stay up and go higher into year end because of the need to “outperform benchmarks.” I shook my head in disagreement and the anchor came back to me. I explained that this was a minor factor now because of the probable recession and global structural issues greatly impacting the economic cycle.

Then I shared my prediction from August 5 that the market would trade between S&P 1,150 and 1,250 in a “wait and see” mode until we knew more about the probable recession.

(See my “Gray Skies” article and video below about how I’ve traded the short-term bottom at S&P 1,120 and profited from the relief rally with strong stocks and bullish 3X leveraged ETFs like UPRO and TNA. I took profits on those Wednesday and went short the market Thursday with SPXU and TZA, the inverse 3X bearish versions.)

As soon as I said it and my time was up, I kicked myself (figuratively, of course) for simply bragging about a prediction that had come true when I could have given them one from August 3 that has yet to be proven.

And that prediction, about the downward EER likely to come, may prove to be as powerful — in an unhappy way — as any positive jobs stimulus we get from Obama next week.”

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The 13 Worst Days in Postwar Market History

What Should I Do Now?

The first thing every investor should do when the stock market goes nuts like it is now, is to take a breath, step back, and don’t panic.  It’s almost always a mistake to join the selling frenzy and sell your stocks during one of these panic episodes.  Keep in mind that if you sell your stocks now, you have to ask yourself – to whom?  There has to be a buyer for your stock, and right now buyers are few and far between.  That means that the few courageous souls who are willing to take your stocks off your hands are in the drivers seat when it comes to price.  They’re not going to pay you a fair and reasonable price, they’re going to demand a big discount from you.  In all likelihood, you’ll probably be selling at prices that are closer to the bottom than the middle of the trading range.

One of the things we insist our coaching clients do is to put in place a contingency plan for situations like this.  Our clients know ahead of time what they’re going to do as the market reaches certain price levels.  If a client has a 10% threshold of pain, they have already sold their stocks.  We’re down 12% from the peak already.  If their threshold is 15%, then they’re still holding on to their stocks.  They may be nervous and stressed, but they’re not in a panic.

Some of our clients use a moving average system to generate trading signals.  One of our most popular is the one month/ten month simple moving average crossover.  This system gave a sell signal last week, and our clients who use it are out of the market.  They didn’t sell because they were panicked, they sold because their system told them to sell.

The thing that’s so difficult about selling your stocks in a market like this is that you have to make two decisions, and you have to be right about both of them.  You have to be right about selling, which means it has to turn out that the market continues to decline after you bail out.  But even more importantly, you have to also be right about when to get back into stocks.  This decision is even more difficult than the selling decision.  How will you know when it’s safe to get back into the market?  Studies have shown that the average investor does a very poor job of making this decision.

But our coaching clients know ahead of time what they’re going to do about getting back in.  Using our moving average system as an example, our clients know that when the one month simple moving average crosses above the ten month  line, it’s time for them to get back into stocks.  They don’t have to worry about missing the turn, because they have a plan in place.

Do you have a plan in place?  Visit our website at zeninvestor.org for details on how to write your plan.

How To Play The Stock Market Game

Investing is not really a game, but your success as an investor depends on how well you understand the basics of “game theory.”  The poker game analogy will be useful as we work our way through the mechanics and strategy of investing.  We chose this because the game of poker has some important similarities to investing.  For example, you are competing against other investors who may be more skilled than you, may have more money than you, or may have better information than you.  The goal of investing, as it is in the game of  poker, is to avoid getting wiped out while you wait for opportunities to win big pots.  Some of the topics we will discuss here include:

  • Rules of the game
  • The players
  • Correct strategy
  • When to cash out

Rules of the Game

  1. Investing is a Zero Sum Game.  This means that for every winner, there must be a loser.  That’s because every time you buy a stock, there is someone else on the opposite side of your trade.  When you buy a stock, you are making a bet that the price will go up.  But the person who is taking the other side of your trade – the seller – is betting that you are wrong.  You can’t both be right.  One of you is going to win, and one of you is going to lose.  Before you buy a stock, you should ask yourself “why is someone willing to sell this stock at this price?”  If the person who is taking the other side of  your trade has done their homework more thoroughly than you, they may know something that you don’t.  As part of our coaching, we’ll teach you how to make a checklist of the questions you should ask yourself before you pull the trigger on any trade.  This is part of the discipline that you will have to have, if you want to compete successfully in the game of investing.
  2. There are no do-overs.  When  you make a mistake and lose money, you can never get it back.  This is because of the existence of the Game Clock.  You only have a finite amount of  time to accumulate your winnings, and once your time is up (you need to start spending your winnings in retirement), your time is up.  For this reason, it’s critical that you learn to minimize your mistakes, and learn from them so you won’t repeat them.
  3. There is no such thing as a stock-picking Guru.  Many investors mistakenly believe that there are highly skilled professionals out there who know how to pick winning stocks consistently.  They figure it’s just a matter of time before they find their personal Guru.  This is not correct.  Stock market Gurus are regular people who are usually smart, hard-working, and extremely lucky.  They achieved the status of Guru because they had a serial run of luck with their picks, and eventually their luck will run out.  This always happens.  Always.  So you need to ask yourself, when is this particular Guru’s lucky streak going to end?  Will I be the last guy to follow his advice just before he crashes and burns?  Beware of the investment Guru, because he doesn’t exist.  It’s better to learn how to pick your own stocks, so you don’t have to rely on someone else for your success.
  4. Don’t put all your eggs in the same basket.  The most common mistake investors make is putting too much of their money into stocks when the market is going up, and then yanking it all out after the market has gone down.  Successful investors have learned that they should always have a balance between stocks, bonds, and cash.  That way they don’t have to panic and sell their stocks when the market takes a tumble.

The Players

Would you walk into the poker room in a Las Vegas casino and play against professional card sharks?  Would you step onto a football field and play against a professional team?  The answer is yes, but only if you have the right skills, ability, and training.  It’s the same when it comes to investing.  You are competing against the best minds and the biggest bankrolls in the world, and unless you know exactly what you’re doing, you will probably get eaten alive.

One way we can divide the players is between the “smart money” and the “dumb money.”  This has very little to do with intelligence or education.  It has a lot to do with preparation and experience.  The smart money is the class of investors who are well informed, usually have lots of capital behind them, and are well connected to the best sources of information.  The dumb money are the folks who are flying by the seat of their pants, hoping that the stock tip they got from their broker, the newsletter they subscribe to, or the guy at the water cooler, will pan out.  The dumb money is what’s called a “low-information” investor.  We’ll teach you how to avoid being the dumb money.

Correct Strategy

There is a right way and a wrong way to invest.  The correct strategy starts with a well-written investment plan, and a discipline to carry it out.  Every time you buy or sell a stock, it should be done within the context of your plan.  For example, you may have decided to put 60% of your money into stocks.  Let’s say that one of the stocks you own announces bad news, and you decide to sell it.  The correct strategy would be to not only sell your stock, but to immediately replace it with another stock that you’ve been keeping an eye on.  That way you will maintain the same 60% allocation to stocks.  There are many other examples of correct strategy, and we’ll teach you all of them.

When To Cash Out

Of all the possible mistakes that investors make, I think the most common, and the most costly, is cashing out too soon.  Most inexperienced investors hang on to their losing stocks for far too long, and then they sell when they just can’t stand the pain any longer.  At that point, the price of the stock is usually near the bottom.  Then, to compound the problem, they wait until the stock has rebounded in price, and by the time they get over the pain of their loss, the price of the stock is near the top of the range.  This is commonly called the ” buy high, sell low” strategy, and it’s undoubtedly the biggest reason that most investors never achieve their true potential.  We’ll teach you how to know when it’s the right time to cash out, and it won’t be based on emotion.  We base our buy and sell decisions on pre-determined rules, so that these decisions are based on reason rather than fear and panic.

If you want to learn how to play the game at the same level of competitiveness as the professionals, become a Premium member of zeninvestor.org and start your training today.

A Short Primer On Risk

Understanding Risk Is Important

Risk is one of the most difficult concepts for amateur investors to master (I use amateur not in a pejorative sense, but as compared to professional investors.)  Part of the reason for this is that investment risk is often counter-intuitive.  Take treasury bonds for example.  Treasury bonds are often described as “riskless” investments.  The theory is that the U.S. government is unlikely to default on its obligation to bondholders, and therefore your money is always safe in treasury bonds because they’re backed by the full faith and credit of the USA.  This statement is true, but it doesn’t necessarily follow that investing in treasury bonds is free from risk.  Treasury bonds trade on the open market, and the prices of treasury bonds fluctuate, just as the prices of stocks fluctuate.  If you invest in treasury bonds at a time when interest rates are historically low, you are in fact exposing yourself to above-average risk.

Bond lovers will counter with the argument that if you hold your treasury bond until it matures, you are guaranteed to receive 100% of the face value of the bond, and therefore they are truly riskless.  My answer to this argument is that very few investors actually buy treasury bonds with the intention of holding them to maturity.  Most investors sell their bonds before they mature, and this exposes them to the risk of selling them for less than their purchase price.  The point is that all investments, including so-called ‘riskless’ treasury bonds, have risk.  You simply can’t escape the fact that nobody can predict with absolute certainty what an investment will be worth when it comes time to sell.

How Much Risk Are You Taking?

Many investors use what I call an Ad Hoc Stock Picking approach.  What I mean by this is that they wait until they ‘feel good’ about their economic circumstances, and then they start picking stocks based on a combination of tips, recommendations, and hunches from all kinds of sources.  It’s called Ad Hoc because there is no unifying theme or context for their choices.  They end up with a collection of stocks that may or may not be appropriate for their circumstances.  And by not considering the prospects for growth in the economy, they risk being too heavily concentrated in stocks at the wrong time.  We advocate a balanced approach to stock picking, which dramatically reduces overall risk while not sacrificing the fun and excitement of ‘playing’ the stockmarket.

Types of Risk

There are two main types of investment risk.  The first is the risk that the market price of the investment will decline and the investor will take a loss at the time of the sale.  The second type of risk is the loss of purchasing power.  Inflation averages about 4% per year over the long term.  If your investment produces a rate of return that is less than the inflation rate, which is often the case with ‘safe’ investments like treasury bonds, then you will find yourself in a situation where you made a profit on your investment but lost purchasing  power.  Would you be satisfied with that outcome?

The Answer

In order to manage these dual risks – price risk and purchasing power risk – an investor has to create an investment portfolio that includes components that will provide some protection against both market downturns and inflation surges.  The only way to do this is with a balanced approach that includes many different types of assets, like stocks, bonds, real estate, gold, hedge funds, private equity, volatility, and others.  The more asset classes you have in your portfolio, the less overall risk you take.  Risk is not a bad thing.  In fact, it’s because of risk that investors are rewarded with returns that are higher than the rate of inflation.  If you have a well-diversified portfolio, you should be seeking risk, not running from it.  Risk is the source of superior investment returns.  But risk must be properly understood, and managed.  Ad Hoc investing ignores this calculation of risk, and because of this, returns are usually disappointing.

The Truth Is Out There

The Seven Noble Truths Of Investing

1. Knowing who you are (as an investor) is important.  If you don’t know who you are, the stock market is an expensive place to find out.  The smart way to go about investing is to first figure out who you are, and then come up with a plan that fits you.  For example, some investors are hyper-sensitive to market declines.  But other investors have a long-term perspective about the market and don’t get upset when it goes down.  If you’re hyper-sensitive to declines, you might sell your stocks too quickly, when the correct strategy might be to hold on, or even add to your holdings.

2. Taking the time to sit down and write an investment plan is the single most important thing you will ever do as an investor.  The second most important thing is reviewing your plan regularly, and making the adjustments that are necessary.

3. Having the right balance in your portfolio is much more important to your long term success than picking good stocks.  Balance accounts for 95% of your results, while stock selection accounts for just 5%.

4. The most powerful force in finance is tax-deferred compounding.  The second most  powerful force is time itself.  Unless you are maximizing both of these concepts, you are giving money away and you will never get it back.

5. If your personal wealth is growing at less than 10% per year, you have a problem with your investment plan.  The biggest causes of leakage are costs and panic selling.  Both of these should be addressed in your written plan.

6. The source of your advice is just as important as the advice itself.  This is because most investment professionals have financial incentives to steer you in a particular direction – the one where they make the most money.  This isn’t illegal, or even immoral.  It’s just the way the business works.  It’s important to develop advice and information sources that are truly independent, and therefore are free to speak the truth.

7. Amateur investors think in terms of what’s possible.  Professional investors think in terms of what’s probable.  It’s possible that you will find the next Microsoft and become fabulously wealthy, but it’s not probable.  It’s both possible and probable that you can grow your personal wealth at a steady 10% annual rate if you stick to a well-written investment plan.

To learn more about these truths, or for help with your investment plan, visit my website at www.zeninvestor.org

Don’t Fight The Tape

How do you explain the behavior of the stock market today? In an environment where almost every piece of news is bad, how is it that the market was able to rally so convincingly? One possible answer can be found in the sage advice of Benjamin Graham – one of the few true gurus of investing. Graham once remarked that “in the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).”

What this means in the context of today’s market action is that investors have voted, and in the short term the bulls have won. The debt ceiling will be raised, the European banks will not disintegrate, and the current earnings season will not bring any nasty surprises.

But in the long term, the market will weigh the evidence and perhaps reach a different conclusion. The lesson to be learned from this is that betting against the momentum of this rally can be hazardous to your portfolio. Our model portfolios remain fully invested in stocks, and as uncomfortable as this may be, we remain steadfast in our commitment.