How Far Will Stocks Fall?

Written By Briton Ryle

Posted January 28, 2015

Oh boy. Stocks got taken out to the woodshed yesterday.

The laundry list of negative news right now is as long as my arm…

  • U.S. economic data is weakening: durable goods orders fell for the fourth straight month.
  • Earnings growth for the S&P 500 has all but vanished.
  • The global economy is weakening — you can see it in commodities prices.
  • Greece’s future in the European Union seems in doubt.
  • Putin is stepping up military action in Ukraine, directly challenging Europe and the U.S. 
  • Iran is ditching the U.S. dollar.

And perhaps worst of all: Facebook crashed for over an hour!!

Okay, sorry for that last one. But what’s a bearish outlook without a little humor?

Now, let’s get serious and see if we can get to the bottom of what’s going on here…

This bull market and economic “recovery” are in their sixth year. That is a long time to go without some kind of prolonged sell-off/economic scare.

Investors know this. That’s why yesterday’s decline was so large and the financial media’s headlines were so dire.

I always preach risk management for investors. That’s why I focus on stable dividend and income stocks in my newsletter, The Wealth Advisory. If you want to consistently grow your wealth in the stock market, study after study shows clearly that dividend stocks are the way to go. 

The problem is, it’s not always easy to stay the course when things look dicey…

Déjà Vu All Over Again

You may not remember, but last year started out this way, too.

The first quarter of 2014 was terrible. GDP growth declined, earnings were awful, and with a price-to-earnings (P/E) ratio of nearly 19 for the S&P 500, stocks looked expensive. 

What’s more, the Fed was expected to get hawkish and wind down QE last year, effectively removing what was seen as important support for stock prices. 

And so the S&P 500 fell 6% in January 2014. The sell-off ended on February 3. 

All that should sound familiar if you’re reading headlines today. The crash for oil prices is in part due to slack global demand, and oil company earnings are down 25%. Multinationals as diverse as Caterpillar (NYSE: CAT) and Pfizer (NYSE: PFE) are missing earnings and lowering guidance. 

The Fed is once again expected to act, this time raising interest rates in the second half of the year. 

And once again, stocks can’t be called cheap, with a P/E roughly in line with last year’s…

Psych 101 tells you that anytime stocks are somewhat expensive, bad news has a bigger impact simply because there’s more to lose. And of course, there’s going to be bad news.

That’s why you can’t take analyst earnings projections — or GDP estimates — as gospel. Growth never comes in a straight line. It zigs and zags, stalls and spurts.

But getting the trend right — whether things overall are getting better or worse — is critical.

Sold Pfizer

I recommended Pfizer to my Wealth Advisory readers in July 2012 at $23 a share. Two years later, we sold it at $30.75 for a 41% profit.

I recommended selling because earnings were going to come under pressure from patent expiration, and there was (and still is) concern about drug pricing. 

The stock fell down to $28 after we took our gains. Today, the stock is trading above $32.

So was I wrong to take profits?

Well, yesterday, Pfizer lowered full-year 2015 profit projections, largely due to patent expiration. So I was right…

But the stock didn’t sell off. In fact, it rallied a little and is higher than when I sold it. So I was also wrong.

In my opinion, whether you make money or not is the final arbiter of right and wrong. My Wealth Advisory subscribers made good money on Pfizer, so I’m not apologizing for selling. The point here is that the stock market works in mysterious ways. 

I’ve been bearish on Caterpillar for almost two years due to weakness in the global economy (sticking with U.S. stocks has been a major theme for The Wealth Advisory). The stock itself is only around 5% lower than when I recommended selling it. It’s held up better than expected, but I still don’t want to own it. 

Expectations are important. They matter. And so I always focus my analysis on what to expect from earnings for a particular company.

Is there reason to expect earnings to improve? Or is there reason to expect earnings to worsen?

This will help you find the right, profitable investments in any market, even now.

Where to Look for Earnings

We are just now getting to the meat of Q4 earnings. So far, they have not been good.

In September, analysts were calling for 8% earnings growth. So far, we’ve gotten just 0.3%. That’s a huge miss. Sure, part of it is oil’s fault, and part of it is the stronger U.S. dollar. 

Q4 revenue was supposed to grow 3.4%, and so far it’s come in just 0.7% better. 

This chart gives you a clear picture of where the action is:

4Q eps

Banks, commodities (materials), utilities, and energy are the drags. For the record, I remain bullish on my favorite bank stock, Bank of America (NYSE: BAC). It remains the cheapest U.S. bank based on book value. And I have been a vocal bear on utilities.  

On the upside, we have health care, consumer discretionary, and tech (I’m leaving telecom off here because, while positive, that sector is not beating expectations).

Now, of these sectors, which has the best opportunity to grow earnings? I say it’s tech, financials, and consumer discretionary. Health care wins the “safety award,” as it probably has the most reliable earnings going forward. 

Consumer discretionary (restaurants, retail, etc.) is the obvious winner of lower oil prices. I’m not wild about financials (with the exception of BofA), but they will do better now that Dodd-Frank has lost some of its punch.

Now, these aren’t the only areas to look for growth. Some of the best gains in The Wealth Advisory have come from real estate investment trusts (REITs). In fact, our best performer has been a health care REIT that’s up 242%. Our other health care REIT is up a respectable 70%.

For a couple years now, we’ve known that REITs were in a favorable spot earnings-wise because low interest rates meant they could raise money to expand very cheaply. And they have.

And REITs have been exceptionally strong since the consensus on the Fed changed to no rate hike in 2015.

REITs have stable businesses, and they pay great dividends — often in the 5% to 8% range. If you’re looking for solid income, I think REITs will do far better than utilities this year.

Until next time,

Until next time,

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Briton Ryle

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.

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