INVESTING WITH CLARITY™ BLOG

EMOTION IS THE COMMOTION!

October 31, 2014 2:45:00 PM

Although many of us are duly aware of the fact that Earnings drive stock prices over the long-haul and Emotion takes over and becomes the driving force of market price swings, most retail investors are not in the here and now.

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In between these two points of time, every market soothsayer, voodoo economist and one-hit-wonder prognosticator attempts to throw out a number that will show the world that they can do the undoable. Ultimately, this greatly confuses the retail investors as they panic and reach for a story to latch onto in order to soothe their fears. As a matter of fact, over the last ten days we have come across one forecast for the S&P 500 to fall to 800 (a drop of 60%) and another predicting the S&P 500 to hit 3,000 (up 50%) in four years.

In all reality, market speculation is a sport engaged in by many and mastered by few. With the S&P 500 recently hitting an Alibaba IPO intraday high of 2,019 on Sept. 19th and subsequently falling 7.2% to 1874, we believe the best perspective for understanding where the markets will go from here is to not follow forecasts from market soothsayers and prognosticators. Rather, we need to get back to the basics of crunching numbers and look to future profits and what we, as shareholders, will pay for the rights to those future profits as our guidepost.

 

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Remember the fact that there has been very little correlation between the predictions of forecasters and the actual outcomes of their predictions. Moreover, it is sad to say there is little to no consequence to them for ever being wrong. Conversely, for investors, the negative consequences of listening to these predictions is substantial as we have been repeatedly shown in the Dalbar Study and extreme underperformance by the average retail investor.

So what is an investor to do? Once again, look to history as a guide for to how to react to the present...

My response is always the same - you did NOT lose money. You only lose money when you SELL an investment at a loss. Investors spend too much time looking at their monthly statements to see how much money they made or lost. The fact of the matter is, you don't make or lose money until an investment is sold! Investments DO NOT go straight up in price.

At Nepsis, we take the position that we are not in a stock market bubble but rather in the second inning of breaking out of a 15-year range-bound market as the chart above (developed by Lord Abbett) certainly shows...

HOW CAN 2.2% ANNUALIZED RETURNS FOR STOCKS OVER A 15-YEAR PERIOD BE A MARKET BUBBLE WHEN INVESTORS DID NOT EVEN EARN THE RATE OF INFLATION OR CASH AND CASH EQUIVALENTS? IT SIMPLY ISN'T AND WE SHOULD STOP THINKING THIS WAY.

In fact, historically, when markets hit a long-term op\, the average PE is over 22x earnings. Today, the S&P 500 is trading at 14x earnings. Can corrections happen at these levels? Yes! However, we would not remotely constitute overall valuations of the stock market today to be in ubble territory.

Well, if Earnings drive stock prices in the long-run, shouldn't we be about the business of determining what they may be earning in the future?

Moreover, shouldn't we also want to know how much we will pay for said earnings? Additionally, shouldn't we stop listening to CNBC, Bloomberg and Fox Business and all of the junk that is spewed from the mouths of mostly charlatans who want to make a name for themselves. Shouldn't we also stop taking the advice of Wall Street conformists who are so deathly afraid of making a mistake, they just default to agreeing with their contemporaries so as to not stand out in the crowd? Talk about a dichotomy of intentions!

As we look to the facts as our guide as seen in the chart below (developed again by Lord Abbett), we see that the calculation process is rather simple and rudimentary. Although EPS growth has been increasing at a clip faster than the historic 6.7% average let us use history as the guide and that percentage as the base case. In the chart Lord Abbett uses both trailing P/E and EPS thus the $111 and 18.1X numbers to arrive at a fair value for the market. So what about next year? The consensus trailing EPS simply rises 6.7% (the historic average) from $111 to $118.40 with no P/E expansion necessary and the S&P could rise to 2,138 by next year. Again, NOT a prediction but simply using historic EPS growth and what we pay for that growth (P/E) to arrive at potential total return of 8.6% which includes the 1.9% dividend yield. If you think the investment public gets more depressed and that P/Es may drop, look at the far right of the chart. If you believe that investors jump back into the game, then you would expect P/Es to go up as in the center of the chart... here are your five basic alternatives ranging from a Flat P/E to an increase/decrease of +/- 1 to 2%.

 

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In closing, we could not have said it better ourselves than the commentary by Lord Abbett; It's All about Earnings, Not Gut Feelings in that the myriad of declarations that we're due for a pullback or his market is becoming a bubble have permeated the financial news airspace in the wake of the S&P 500 reaching the 2,020 mark.

We believe this is not a time to make a directional bet on stocks based on a belief that we're due for something, but rather an opportunity to invest in companies that are able to navigate a slow-growth economy.

So do Earnings and or Emotions drive the market? We would say yes to both. Emotions drive the market in the short-term world of trading, while earnings drive the market in the long-term world of investing. Where will you set your claim, as you can't win at both?


Mark Pearson

Mark Pearson

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