Understanding the Stock Market

Hello, and happy Monday.

There is a LOT going on in the markets these days. But then, that’s always true. The stock market is the Great Discount Mechanism, sifting reams of info every day and spitting out judgment in the form of price action.

Of course, it’s a machine of human construction, and like any intelligence — real or artificial — it is not always correct, rational, or reliable.

But that doesn’t mean it doesn’t pronounce its judgment with authority. Every day’s closing prices are real and binding, for that day anyway. And because it’s our money, we listen.

I gave up trying to perfectly understand the stock market years ago. It is not a perfect machine, and treating it as such will drive you crazy and probably cost you money. (However, I have also learned that, over time, the stock market will get pretty close to the right answer.)

I tend to sift through the cascade of information, collect the nuggets that seem reasonable, and take what I can from them.

So here are a few nuggets that I’ve come up with over the last week…

• Earnings are the single most important factor for stock prices. When earnings are rising, so are prices. When earnings stagnate or — gasp — fall, that’s when things get dicey. The problem is, everything affects earnings: the weather, Fed policy, fiscal policy, commodity prices, consumer confidence, wages, taxes, prices, productivity, and on and on. The variables are virtually endless, and there is no formula you can use that will give you a reliable answer. You might as well ask, “Are current conditions conducive to growth?” The answer is as much guesswork as science. The latest guesses for 2015 S&P 500 earnings have come down from $127 a share to $122. A couple weeks ago, when stock prices were hitting new highs, some investors wondered how prices could be rising while earnings expectations were coming down. Now we know…

• The U.S. dollar has put in its sharpest rally in 17 years. As you might guess, the dollar does indeed affect corporate earnings. If you’re doing business overseas, you’re getting fewer dollars in return for whatever currency you’re operating in. And that’s going to show in your quarterly reports. 

• The U.S. dollar is also something of a safe haven. When you’re worried about the future of your own currency, you buy dollars. If I owned euros, I would have started converting them to dollars the minute I saw the “Greece Rejects Bailout Terms” headlines. Yep, the future of the EU is once again in question. And yes, that would definitely affect S&P 500 earnings. The massive USD rally has investors nervous that something bad is looming…

• Canada and Australia recently cut interest rates. The EU just started its $45 billion a month in QE. And China lowered reserve requirements and cut rates. Even Russia just cut rates. This is what central banks do when growth is lackluster. Yes, slowing global growth is bad for S&P 500 earnings. 

• When the latest jobs report blew expectations out of the water, investors panicked. This was the final nail in the zero-interest-rate coffin. Surely the Fed will raise interest rates in June, putting the brakes on a U.S. economy that’s doing 30 in a 40 mph zone. Estimates for first quarter GDP are between 1.2% and 2.2%.

• Will the Fed hike rates while the rest of the world is still easing and inflation is well below target levels? If the Fed does hike rates, it will be because the members believe the momentum in the labor market is for real and will eventually lead to wage inflation. Don’t forget, several of our lowest-paying employers like Wal-Mart (NYSE: WMT) and McDonald’s (NYSE: MCD) recently raised their minimum pay levels. I’m starting to think the Fed will not hike in June, at least, and may not hike at all if real growth doesn’t pick up.

• Most investors are aware that global and domestic growth is not all it could be. And inflation is well below target levels. In Europe, deflation is still on the table. That’s why the interest rates on some sovereign debt (like Denmark) actually went negative. Yeah, you get back less than you put in. Up until recently, negative real rates were thought to be impossible. Why would anyone buy a bond knowing they wouldn’t get all their money back?  

• I recommended Bank of America (NYSE: BAC) to my Wealth Advisory subscribers in 2012 at $9.10 a share. Yes, my readers have done well with this one — it’s up 77%. Right now, I’m trying to resist the urge to recommend selling the stock. Sure, it’s cheap — 30% below book value. But I am absolutely pissed off that BofA didn’t hike its dividend as part of its 2015 capital plan, opting instead for a $4 billion share buyback. Why? Because dividends are about shareholders; buybacks are about a company’s executives. A company buys back shares in order to compensate the bigwigs and also to make year-over-year earnings growth look better. Bank of America’s shareholders have been through a lot — roughly $70 billion in mortgage settlements over the last few years. Now that BofA is really getting back to profitability, shareholders deserve more of the action. Management can go suck eggs. I know I must separate my emotions from my investment decisions, and I will… even though I really want to send the company a message, and they are not answering my emails.

• Stock buybacks have been an important source of earnings growth over the past few years. They’ve helped push stock prices higher. But this is not “real” growth. Buybacks simply lower share counts. What happens when buybacks stop? Earnings won’t grow as much, and prices may suffer. 

• It hit me on Friday — watch for McDonald’s (NYSE: MCD) to buy one of the upstart burger joints: Shake Shack (NYSE: SHAK), Habit Burger (NASDAQ: HABT), or Good Times (NASDAQ: GTIM). McDonald’s blew when it divested its early investment in Chipotle (NYSE: CMG), missing out on the lion’s share of the company’s growth that would have meant billions in profit. And sales at McDonald’s are not growing. If you can’t beat ’em, buy ’em.  

• The strong U.S. dollar has certainly had an impact on oil prices. Oil was showing some strength before the dollar really took off. Last week, a Bakken giant let it slip that it was looking for a bigger company to buy it out. So far, no word on a potential suitor, but I bet we see oil stocks rally when one emerges. I gave out a list of my top eight buyout candidates in December, and the list still looks pretty good.

• The S&P 500 has sold off for three weeks. But solar stocks and biotech have been strong. It seems like not a day goes by without an announcement of plans for a new solar installation. 

• I suspect stocks are “re-setting” to account for rising interest rates, a stronger dollar, and continued tepid growth. A rate hike might cost the S&P 500 ~10%, and it’s off 3.6% from recent highs. I also think it will be a while before we see more new highs for the S&P 500. I expect we will see the S&P 500 settle into a range between maybe 1,850 and 2,050, but still with an upside bias. In other words, there will be lower prices, so you will have an opportunity to get stocks at lower prices. At the same time, as I said before, I’m starting to think the Fed will not hike in June.

• In my 2015 predictions, I said tech stocks would lead the S&P 500 this year. So far so good. I’ve added a few nice dividend-paying tech stocks to The Wealth Advisory portfolio, including Juniper Networks (NYSE: JNPR). One reason I like it is that it is more focused on the mobile phone market, where Cisco is in traditional network space. Mobile seems to be growing faster. The stock is up 7% so far this year, while the S&P 500 is down a couple points.

• There are a few gold miners trading below cash right now. Buy the company, get the gold for free. Of course, you still have to get it out of the ground… I can’t tell you that gold miners are going to rally. Gold prices have been pretty stable, and it hasn’t mattered for the miners. These stocks are hated, and if you’re a contrarian, that’s interesting.

OK, that’s what I’ve got for today. Take care, and I’ll be back on Wednesday.

Until then,

Until next time,

Briton Ryle

@BritonRyle on Twitter

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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.