What Makes Stocks, Market Go Up/Down? Part 2

This week I will write about the second most important variable, earnings. If earnings are growing, then the stock price should reflect the increase in wealth earnings bring, if the company is losing money the stock price will reflect the loss in wealth.

Think of your own personal wealth: income (annual) minus expenses (annual) = accumulated invested capital.

Investors are looking to grow their invested capital (adjusted to risk) to protect their investment dollar’s purchasing power.

If you went to business school, just about every class from human resources to accounting first taught us the job of every manager, company is to grow shareholder wealth. As a shareholder of a company, shareholders should benefit from the growth.

Below is a chart that shows the relationship between earnings and the growth in the Dow 30:

Source: Dan Hassey database

The chart shows the strong relationship of earnings and price. When earning are rising, the markets rise. The last two recession in 2001, 2008 we see earning decline and so did the market. When earnings recovered, so did the market.

Let’s take a closer look at this cycle. Below is a spreadsheet with the valuation metrics including earnings for the Dow 30 from 2007 to 2014:

Source: Barron’s, Dan Hassey database

Middle Column, 12-Mth Earns

Earnings peaked in the previous bull and market cycle in the summer of 2007 at $824.65.

Earnings fell from $824 to a -$115.29 about one year later.

Earnings started to consistently grow starting with the winter of 2009.

Earnings are starting to slip because of the strong dollar, oil prices collapsing, cold weather and the west coast port strike. The market reflects the weakness as prices have traded sideways since late last year, see chart below.

Earnings are expected to start growing again, and are forecasted to be around 1,218 in 2016.

If we give the market a 16 P/E (close to the historical average) then the market could be around 19,488 (1218 earnings forecast times 16 P/E)

P/E Ratio Column

P/Es normally are very high during a recession. This phenomenon is known as the Molodovsky effect. According to Security Analysis (a book that must be mastered by professional and serious investors) the effect is the tendency of a company suffering temporarily depressed earnings to sell at a high price-earnings ratio.

Once earnings recovered P/Es stayed low because of the many global risks.

The market P/E ratio suggested that the markets were undervalued/risky for much of the recovery, but now the P/E is about the historical average, suggesting the market is fairly valued.

Some of the markets appreciation is due to the P/E expansion from around the high 13s to the current 16.5.

Last Two Columns, 12-Mth Divs, Div Yields

The last two columns show the changes of actual dividends paid and dividend yields for the Dow 30.

Dividends peaked at $325.27 in the previous market cycle that ended in 2007. During the Great Recession, dividends were cut to $272.78.

At the end of 2008, I realized that the market was oversold and probably undervalued and that dividend growing stocks was the place to be especially if you were retired or close to retirement. We started the Baby Boomer service in late 2008 and we were fully invested by the end of 2009.

If an investor would have bought the market at the end of 2008, at about 9,000 you’re dividend would be about $316 and your yield would be about 3.5%. You would have doubled your money in terms of appreciation, and your dividend yield would be about 4.3%, more than most income producing investments, and you can expect the dividend to grow over time.

Many of our Baby Boomer recommendations have had similar success.

Dow 30 Closing Avg. Column

The third column has the closing prices for each quarter. Before the bear market, prices peaked in the fall of 2007.

Prices bottomed in the 1st quarter of 2009, and have been in bull market mode since then.

Here is a Dow 30 chart for this bull market:

The Dow fell over 50% from its peak in October of 2007, to its bottom in 2009.

As I’ve written about many times, when prices fall to bear market territory prices will normally base. The market started to base in October 2008, about one year after the market’s peak.

It is normal during a basing period for prices to test the lows and even make new lows. 

The final low was made in March of 2009. We had the one day reversal (prices make a new low, but end the day at the high of the day with significant volume), a sign of a bottom.

Most basing periods last about seven months. The basing period lasted about 11 months because of how serious the Great Recession was, and the damage done in the bear market that was down about 50% from peak to trough.

Both 2010 and 2011 were tough years, especially 2011.

The global economy and markets had to deal with several major events in 2011: the sovereign debt crisis in the Eurozone, the Arab Spring and the potential for oil supply disruptions, Japan’s triple tragedy (earthquake, tsunami, nuclear facility disaster) that slowed trade with our economy.

The market did almost reach bear market territory during 2011, but did recover toward the end of the year. Despite these unfortunate events, the economy, earnings, and dividends did grow in 2011. We did not enter into a recession, and is why the market recovered fairly quickly toward the end of the year.

We now see that the market has been trading sideways since late last year. If earnings forecasts prove to be correct, the market should be over 19,000 in 2016.

Lessons

• Growth in earnings are a key to higher dividends and stock and market prices. A loss in earnings leads to the opposite. This is why I focus on earnings in my monthly market outlook, but I also look at the trend in earnings forecasts: are they going up, down or is the earnings trend stable.
  
• Be aggressive and think long-term at the beginning of an economic and market cycle. Start buying during the basing phase of a bear market. Values are better, dividends are higher, prices are much lower, and downside risk is normally less and normally the upside potential is much greater.
  
• Caution needs to be taken toward the end of a cycle: values are higher, dividends are lower, revenue and earnings comparisons become tougher, prices and risks are normally higher toward the end of a cycle. As the cycle matures, it makes more sense to think shorter-term than at the beginning of a cycle. Also, if the market does enter into a bear market, the average bear market is down about 30% and they occur about every four to five years, on average. In March, we entered the 7th year of this bull market. Raising cash at the top of a cycle allows you to take advantage of oversold, and undervalued stocks when an inevitable bear market occurs.
  

I have been writing that this economic and market cycle is lasting longer because the economy is growing more slowly and inflation is subdued allowing the Fed to keep rates low for a very long time.

Longer market and economic cycles may be a new trend in future cycles because of a bigger, slower economy.

Lastly, for investors, it is better to follow free cash flow of a company or asset like real estate. I will write about this important investment topic in a future article.