Most prognosticators focus on one single idea to predict where the market is headed, they focus on earnings growth. This common idea is straightforward, if corporate earnings continue to rise, stock prices should follow.
The reality is for more nuanced.
While growth in earnings is extremely important over the long-term, over the short-term it’s investor sentiment and valuation levels that move the market. That’s why we believe it’s important to look beyond the headline numbers and understand the assumptions behind many stock market forecasts.
Returns are made up of 3 components:
Returns = 1 Dividend Yield + 2 Earnings Growth + 3 Change in Valuation (P/E Multiple)
The first two components are relatively intuitive. Companies generate earnings, many pay dividends, and over time those earnings tend to grow.
The third component (P/E), the price investors are willing to pay for those earnings, is frequently not considered, but can have a dramatic impact on returns.
When investors become more optimistic, they’re often willing to pay higher P/E multiples, pushing stock prices higher. Conversely, when sentiment becomes more cautious, P/E multiples can contract, even if corporate earnings are growing.
Why This Matters
Investors sometimes incorrectly assume that, “if earnings are going up, that the stock price has to go up.” Unfortunately, this is not the case, and there are many times the opposite happens…stock prices fall even as earnings are growing.
To give just one example, Microsoft stock in early 2000 hit an all-time high, then proceeded to lose 74.5% of its value over the course of 9 grueling long years. And it took a full 16 years to get back to its original high in 2000. During this same 16-year period, Microsoft earnings per share tripled!
Investing Isn’t About Predicting, it’s about preparing.
We don’t believe anyone has a functioning crystal ball.
This means investors must
- Understand what they own, why they own it, and what it’s being valued at.
- Perform stress tests under various market and economic conditions.
- Avoiding emotional investment decisions driven by market headlines.
- Taking advantage of opportunities when markets become mispriced.
A Special Consideration for Retirees
For investors approaching retirement or if living off their portfolios, market declines can have a much greater impact than they do for younger investors. This is known as sequence-of-returns risk, when significant losses occur early in retirement while withdrawals are being made. For these clients, portfolio construction and stress testing is critical and becomes even more important than return forecasts.
Our Perspective
Forecasts make for interesting headlines and cocktail party conversations, but they should never become the foundation of an investment strategy.
Markets are influenced by countless variables that no one can consistently predict. While earnings matter, valuation matters just as much, and sometimes more, especially over the short-term.
There is axiom on Wall Street that holds true, valuation doesn’t matter until it does.
-Paul R. Rossi, CFA