The stock market is all about expectations. It’s not where a stock price is today… it’s not how many units of a product the company sold over the last quarter… it’s where these things will be tomorrow that really matters.
That’s not to say that current stock prices and sales numbers don’t matter — they do. But they are like mileposts. They tell you how far a company has come and hopefully give you some idea of where the company is headed.
Let me give you an example using S&P earnings.
Now, you may have heard people say that the stock market is expensive lately. That observation is based on the trailing price-to-earnings (P/E), which is a way of valuing companies based on their earnings numbers over the last year. Right now, the P/E for the S&P 500 is around 23. And yes, that’s historically a bit high. But the forward P/E ratio for the S&P 500 — which is based on analyst expectations for the next year — is a much more reasonable 16.
Yeah, there’s that word again — expectations. Analysts are expecting a big jump for earnings per share over the next year. That includes the current earnings season (third quarter), which started about two weeks ago.
If you’re wondering why analysts are expecting a big jump in earnings numbers, well, good question. I mean, has anything really changed in the economy? Growth still stinks, wages aren’t rising much, inflation is weak, and if you look at the rest of world, ugh, it looks terrible. Anecdotally, the case for better earnings seems weak.
So, last week, when Goldman Sachs lowered 2016 earnings estimates for the S&P 500 from $110 a share to $105 and 2017 from $123 to $116 (I’m not including their estimates for 2018 ’cause it’s just silly to project earnings out that far), you might have said, “Uh-huh, there it goes, earnings expectations were too high. Now the stock market is going to sell off.”
And it would have sounded pretty reasonable. Except that the S&P 500 didn’t sell off (at least not much).
As it turns out, Goldman Sachs’ revision wasn’t bad news. In fact, we could even conclude that it was good news, as in, investors were expecting worse.
Because the thing is, forward earnings expectations are pretty much always too high. Analysts tend to lower them by 4–5% in the three-month period before any quarterly earnings season starts.
That’s why Goldman’s earnings revision wasn’t a bombshell. In fact, most news isn’t…
Which News is Important?
The stock market is a discounting mechanism. Stock prices move as investors attempt to put a monetary value on news. That’s what it means when you hear someone say a news item is “priced in.” That’s particularly relevant given that the S&P 500 has been trading in a very tight range — between 2,130 and 2,170 — since September 9.
You can think of a tight trading range as a kind of equilibrium. Investors have basically priced everything in. And we haven’t gotten any news significant enough to push the index higher or lower. So the trading range persists…
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To this point, I haven’t heard a lot of macro concerns from companies. Companies aren’t complaining about the strong U.S. dollar or fears of an interest rate hike or increasing tensions with Russia.
Yeah, I’ve heard a few companies mention the coming election as a reason their business has been weak. I mean, I can see why investors wouldn’t be buying biotech stocks till they see which way the wind is blowing. But who says, “I’m not buying those pants till I know who’s president”? An election is no reason for a company to miss earnings.
Speaking of the election, it’s just a few days away. And it would certainly seem reasonable to think that some of the reason the S&P 500 has been trading in that tight range is related to the election. Let’s dig into that a little deeper…
I’ve been using one stock as my “election barometer” — biotech Gilead Sciences (NASDAQ: GILD).
Now, if you don’t know, biotech stocks have been weak for months, ever since Hillary Clinton started to make noise about drug pricing. Gilead was a specific target because of its hepatitis drug Sovaldi, which is very expensive. Gilead and other biotechs sold off as investors worried that Clinton would force companies to charge less for drugs, and then they’d make less money, and so forth. (Never mind the fact that a big reason for continued hikes in health insurance premiums is due to drug costs — investors don’t want to hear that.)
I’m going to go out on a limb here and say that it sure looks like Clinton is gong to win this election. So you’d think Gilead shares would be trading lower, right? Not so fast…
Gilead has been doing pretty well over the last couple of weeks. It’s up about $3 (5%) since I first mentioned it as a stock to watch to my Real Income Trader members. All in all, the S&P 500 seems to be taking everything in stride, and that suggests the range will be broken to the upside.
Now, please understand, I’m not telling you that Gilead is making stocks rally. Rather, I’m using Gilead stock as a sentiment indicator. The logic is: if investors feel good about the stock market, then they will buy Gilead.
(For clarity’s sake, I also use oil prices as a sentiment indicator. But oil is traditionally more of an economic sentiment indicator — economic strength suggests rising demand for oil. Of course, it’s a bit more complicated than that right now, given the OPEC BS. And beaten-down oil stocks have some upside, which is why they sometimes rally when oil is down.)
I try not to impose my beliefs and biases on the market. And I’m not arrogant enough to think I’m smarter than the market. That’s a good way to lose money. It’s much better to try and read the tea leaves, find out what the market is actually saying.
And the recent action in Gilead tells me investors are OK with where things are. And I’m OK with that, too.
Until next time,
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.