I often hear statements such as “the market has already priced in factor XYZ”. These include “the stock market has already priced in strong earnings growth”.
Based on what I’ve seen, these statements are just wild guesses. Nobody knows what the market has or hasn’t “priced in” – trying to guess what is “priced in” is a silly game.
Fact is, the market doesn’t care what is or isn’t priced in. The market cares about facts: are earnings growing or are earnings decreasing.
This is why earnings expectations are very important. The following chart (red line) demonstrates earnings expectations for the S&P 500.
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As you can see, bear markets in the stock market occur when earnings expectations are falling. This means that rising earnings expectations = medium-long term bullish for the stock market.
- Expected earnings growth fell from late-2000 to early-2002, while the stock market was in a bear market.
- Expected earnings growth fell from late-2007 to early-2009, while the stock market was in a bear market.
Now here’s the secret.
Analysts are actually quite good at predicting earnings. Some analysts might overestimate a company’s earnings, and other analysts might underestimate a company’s earnings. But on balance, the average estimate will be quite close to reality.
This means that if 12 month forward earnings expectations are going up, then earnings probably will in fact go higher in the next 12 months, which is bullish for stocks.
There is only 1 scenario in which analysts get earnings expectations wrong, and that’s when the economy is about to enter into a recession.
Remember, analysts don’t know how to predict where the economy will go next – they just predict what the company’s earnings will do based on the economy’s current state. So what tends to happen is that analysts are too optimistic about earnings when a recession begins. Once the recession begins, analysts rapidly downgrade their earnings expectations.
In summary, this means that:
- You can trust analysts’ earnings expectations, which on balance are pretty accurate.
- The only time you shouldn’t trust analysts earnings expectations is when the economy is on the verge of a recession.
The stock market will head higher as long as earnings continue to go higher, regardless of valuations. Valuations can’t be used to time bull/bear transitions in the stock market.
Analysts expect earnings to go higher over the next 12 months. This is a medium-long term bullish sign for the stock market. Earnings expectations continue to go higher despite the tariff threats.
It is unlikely for analysts to get their earnings expectations wrong right now because the risk of a recession in the next 12 months is very low.
Professor Tim Duy wrote a pretty good piece on why a recession is unlikely (I agree, and so does the Medium-Long Term Model). The early warnings signs of a recession just aren’t here.
Here are some key takeaways:
- Recessions don’t happen out of thin air. Data starts shifting ahead of a recession. Manufacturing activity sags. Housing starts tumble. Jobless claims start rising.
- For a recession to start in the next twelve months, the data has to make a hard turn now. Maybe yesterday. And you would have to believe that turn would be happening in the midst of a substantial fiscal stimulus adding a tailwind to the economy through 2019. I just don’t see it happening.
- As far as the Fed is concerned, I don’t think we are seeing evidence that policy is too tight. The flattening yield curve indicates policy is getting tighter, to be sure. But as far as recession calls are concerned, it’s inversion or nothing.
- But many, many things have to start going wrong in fairly short order to bring about a recession in the next twelve months. It would probably have to be an extraordinary set of events outside of the typical business cycle dynamics. A much better bet is to expect this expansion will be a record breaker.
I agree with all 4 points.
- Recessions don’t come from thin air. The economy doesn’t just go from 3% or 4% growth to negative growth in a heartbeat. The economy simply doesn’t move as fast as the stock market. It’s a slow transition process. And with very strong GDP growth right now, a recession in the next few quarters is highly unlikely.
- Fiscal stimulus through Trump’s tax cuts is a massive boost to the economy. The tariffs are small potatoes next to fiscal stimulus.
- We’ve demonstrated this in the past. The market goes up when the yield curve is flattening. The market goes down AFTER the yield curve has inverted. Timing is important, and a flattening yield curve means nothing.
- This is probably going to be the longest economic expansion in history because it has also been one of the weakest. Economic expansions don’t die of old age. They die of excess.
With that being said, I find it encouraging for bulls that both earnings expectations and expected profit margins continue to expand.
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