The underlying value of stocks is falling yet prices keep moving higher in what might turn into a stock crash for unsuspecting investors
Companies have begun reporting their earnings for the first three months of the year and the picture is pretty bleak. Corporations have seen their profits fall for nearly a year and it doesn’t look like things are going to change for the better. Investors have tried to remain optimistic, clinging to Wall Street estimates for a rosy second half of the year but optimism alone won’t support stock prices. Even if a stock crash doesn’t derail the seven-year bull market, investors might want to reevaluate the risk in their portfolio.
I am normally a pretty calm investor but lately I’ve been sitting here wondering if the rest of the stock market has gone bat-s&^! bonkers.
I am just as optimistic as the next guy when it comes to my outlook on life but I’m a stone-cold numbers guy when it comes to investing. Numbers don’t lie. They don’t try to rationalize and they don’t make excuses.
And the numbers are not looking good for stocks right now.
Could Falling Earnings Bring a Stock Crash?
Wall Street is expecting earnings of companies in the S&P 500 to fall 10% from the same quarter last year. That’s the sharpest drop since 2009 and would mark a full year of falling profits with 15 months of falling sales.
It doesn’t take a Wall Street analyst to see that stocks are in trouble. Buying shares of a company gives you an ownership in future earnings. The price you pay for those shares, or the price someone will pay you, depends on the amount of profits generated. If earnings fall then your stock is worth less. Wall Street can argue that the future looks bright or that investors are willing to pay a higher price for lower earnings to talk itself out of a stock crash but it doesn’t change this simple math.
Earnings of S&P 500 companies have been falling since October 2014, now down 14% through last September but expected to be even lower when first quarter earnings are reported. What has the stock market done over the period? The index is up 4% as pundits search for reasons why ‘this time is different’ and falling earnings do not mean falling prices or a stock crash.
Looking at the seven instances where corporate profits have fallen five quarters or more since 1970, all but one resulted in a stock crash.
Even as Wall Street tries to talk itself out of a stock market crash, analysts and corporate management are getting more negative on the situation. Over the last three months, analysts have cut their expectations for corporate earnings by 10% for the largest decline since 2009. Corporate profits are not expected to be positive until the third quarter which won’t be reported until October. Of the 121 companies that have pre-announced their earnings, 94 warned investors that profits would miss expectations.
On the worry over falling earnings, it’s no wonder that the Stable Earnings fund on Motif Investing has gained 7.6% over the last year, easily beating the rest of the market. The fund holds 23 companies that have proven their earnings consistency and businesses that are less impacted by an economic downturn.
Even without a Stock Crash – Are Stocks Too Expensive?
Even if the market can avoid a full-on stock crash, there might not be much upside left to stocks. Despite five consecutive quarters of falling profits, analysts are still predicting full year earnings growth of 2.2% for 2016. This narrow optimism is keeping stocks extremely expensive, trading at 16.1 times expected earnings, nearly 14% more expensive than the 10-year average of 14.2 times expected earnings.
And if earnings don’t come out as expected, stocks will start to look even more expensive. Analysts are notorious for being too optimistic about future earnings. Nobody expected earnings to fall by 54% over the five quarters through 2001 or to plunge 90% over almost two years through March 2009 but it happened and the stock market got destroyed.
I’m not predicting a stock crash over the next year but stocks don’t have to tumble for investors to lose money. The economy is barely moving, the Federal Reserve has taken its foot off the gas and all the same geopolitical risks like Greece and E.U. secession votes are still simmering. Earnings are not growing, there is little real reason to believe they’ll get any great boost in the second half of the year and stocks are already very expensive.
The best case scenario is for a go-nowhere stock market where investors escape with no return at all.
You don’t need to sell out of all your stocks and put the cash under your mattress. Not all stock sectors are as expensive as the general market. Stocks of financial companies are trading right around their 10-year valuation and may benefit from higher interest income as the Federal Reserve lifts rates. Stocks of healthcare companies are also trading relatively cheaply is one of the few sectors expected to post positive earnings growth this quarter.
Healthcare is one of my favorite long-term investing themes and a key component of my American Future Fund on Motif Investing. The aging population in the U.S. and abroad will drive earnings for healthcare companies for several decades, meaning even a stock crash this year won’t derail long-term upside. Check out the four stock funds I created on Motif or click through to Motif Investing to create your own stock funds.
If you haven’t re-balanced your investments for several years, it’s likely that stocks have become a big percentage of your total wealth and it may be time to put a little of that money in the safety of bonds. A lot of this will depend on your own personal investment plan and how much return you need to meet your investing goals.
A stock crash doesn’t have to throw you off your long-term investing strategy. You may not even need to worry about it if you have investments in safer bonds and stocks with stable earnings. It’s important that you see through the perennial positivity in the market and understand what falling earnings really mean for the stock market. That way, even if stock prices tumble, you won’t be overly surprised and find yourself panic-selling out of your portfolio.