Does The Stock Market Matter To Trade?

On Monday, Commerce Secretary Wilbur Ross claimed there was no level the stock market could fall to that would cause the President to change his trade policy. It’s not surprising to hear the White House claim this because if it stated there was a level the market could fall to, the countries negotiating with America would get the upper hand. In a game of chicken, you lose if you name your breaking point. It’s possible market participants would test that level to see what would happen.

It’s important for investors to understand that the stock market matters a lot to the negotiations on America’s side. Obviously, there is a breaking point on each side, but we don’t know it. Because earnings are up so much this year, the trade tariff stories haven’t been able to push the market down. Trump is using his leverage to get the best deal. The longer this negotiation lasts, the more likely stocks will fall, forcing a deal.

Are Buybacks Holding Up The Market?

As I mentioned earnings growth is holding the market up. Some say buybacks are keeping the market up. That’s essentially the same thing. Buybacks happen to be one of the best ways capital can be deployed. However, without earnings growth, you don’t have the explosion in buybacks. The key points to understand are that buybacks aren’t bad for firms and that they don’t cause bubbles. If you say buybacks cause bubbles, the same point can be made about any catalyst which drives stocks up. It’s turning anything that’s good into a bad sign. The two issues to keep in mind with buybacks are when the share count goes up even with buybacks because of stock-based compensation and when excessive debt is taken out to fund buybacks.

Great Q2 Earnings Results

According to FactSet, the bottom up EPS estimates from Q2 increased 0.8% which is amazing because every quarter from Q1 2011 to Q4 2017 saw estimates decline. Besides last quarter, this intra-quarter earnings estimate boost was the largest since Q2 2010. This quarter is the 2nd one since Q4 2010 where the estimates increased, and stocks increased. Most of the quarters saw earnings declines with an increase in prices. As long as earnings growth is occurring, a decline in estimates isn’t the end of the world, but clearly, it’s better for them to go up.

According to The Earnings Scout, last week Q2 earnings growth estimates went from 18.49% to 18.95%. Arguably more importantly, Q3 estimates went from 23.71% to 23.82%. Q3 will be the peak of earnings growth. Remember, that peak earnings growth doesn’t mean a peak for stocks. As you can see, the stock market is biased to the upside as neither peak growth nor estimate declines mean lower stock prices. You can say America is in a 242-year bull market since its founding. Finally, Q4 estimates were up from 15.4% to 15.44% and Q1 2019 estimates for growth went up from 6.63% to 7.11%.

I won’t be bearish on stocks until I have reason to believe the 2019 estimates are way too high. It’s a very difficult prognosis to make, since it’s so far in the future. That’s why you make so much money on that call if you are right. Since this is a difficult call, many trend followers wait for a confirmation which means missing out on the exact top, but avoiding a majority of the losses in the bear market. Confirmation would be analysts lowering their estimates.

Earnings season really kicks up into high gear when the banks start reporting in less than 2 weeks, but as of the end of last week 20 firms had reported earnings, meaning there is relevant data worth discussing. You can see earnings affecting the market directly during the meat of earnings season, but each report has a small impact on the index as well. The table below lists all 20 firms which have reported earnings. 6 firms saw their Q3 earnings estimates revised higher and 12 saw their estimates revised lower.

If you are picking individual firms to invest in, utilizing this information can provide alpha. The stocks of the 6 firms which saw their estimates pushed higher are up 11.65% year to date which is 998 basis points better than the overall index. The 12 firms which saw their estimates revised lower are down 0.42%. That is 209 basis points of underperformance. This explains the overall market’s action as the firms which had their estimates move up have seen their stocks rise substantially while the firms which saw them decline are barely down. These trends are the underlying fundamentals which move the market outside of the flashy headlines which come from the trade war story.

Stocks Are Much Cheaper

Since earnings growth is strong and the stock market is barely up, stocks have gotten much cheaper this year. I was always expecting multiple compression because stocks were only expensive last year in anticipation of the tax cuts. Almost all the benefits of the tax cuts were seen in 2017. The question for 2018 is how much multiple compression there will be. So far, there has been meaningful compression as you can see from the chart below which breaks the multiples down by sector.

All the sectors have seen multiple compression. Since the consumer discretionary sector is up 11%, it has only seen its forward multiple fall from 21.1 to 20.7. It’s interesting to see this sector doing so well considering the weak consumption growth seen in May. The financials are a key sector to watch because they have recently dragged the market down. They have seen their forward PE multiple fall from 14.8 to 12.2 which is the 2nd lowest multiple and an 18% decline. Most sectors are down, but since the biggest sector, which is tech, is up, the market is up. It’s probably wrong to measure energy and industrials on their earnings multiples because when their earnings peak, the stocks look the cheapest, but they are strong sells. When the stocks are expensive, they are strong buys because their earnings are troughing.