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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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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.