Why the Stock 'Market' Is Like No Other Market

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Chuck Carnevale submits:

Introduction

In light of the recent volatility in the stock markets, this article is offered as an update and addendum to the article: Stock Market Should Be Renamed " The Stock Auction " which we offered on May 12, 2010. There are important and undeniable realities that we are discussing. Stock price charts, no matter what length of time plotted, hours, days, weeks, months, years or even decades, are always very jagged lines. In other words, stock prices do not move in a smooth and consistent fashion.

On the other hand, fundamentals like earnings and cash flows tend to draw a much less erratic line or picture. One reason why, is that fundamentals are typically only reported four times a year, or quarterly, whichever comes first. Joking aside, ultimately in the long run fundamentals matter more than volatile price action regarding the true value of a stock, portfolio or index.


Figure 1 below is an updated price correlated to earnings EDMP, Inc. F.A.S.T. Graph for the S&P 500 since our previous article on May 12, 2010. The green line with white triangles is a plotting of S&P 500 operating earnings per share since 1996 multiplied by 15, the average PE for the S&P 500 for the past 80 years. The average growth rate of earnings since 1996 for the S&P 500 has been 5.2%. The blue line with asterisks depicts the 20-year normal PE ratio of 17.5 for the S&P 500 over the past 20 years. Note that it's only due to the infamous irrational exuberant period form 1996-2000 that skewed the normal PE above the longer term normal 15 multiple.

Also note that the operating earnings estimate for 2010 has increased to $81.62 from the previous estimate of $78.36. If you apply the normal 15 PE to the $81.62 earnings estimate you get a 2010 ending fair value of 1224. At 17.5 times earnings of $81.62, the fair value number is 1428 for the S&P 500. That represents range of 14% to 33% upside from the May 20, 2010 close of 1071.59. There is no time on the graph where the S&P 500's price has fallen materially below the 80-year normal PE ratio of 15. Also at a 16.1 blended PE, the S&P 500 is close to its normal fair value based on earnings

(Click charts to enlarge)

Figure 1: S&P 500 15yr EPS Growth Correlated to Price
Figure 1: S&P 500 15yr EPS Growth Correlated to Price

The Store Where You Buy Stocks

Imagine that you were going shopping at your local Wal-Mart ( WMT ) store. As you drove into the parking lot you noticed it was full of cars. Then as you entered the store, the isles were full of shoppers with loaded shopping carts.

Suddenly, the store manager's voice comes over the PA system with the following announcement: "Ladies and gentlemen, for being such loyal Wal-Mart customers we are going to reward you. For the next hour, all merchandise in the store is going on sale at 10% off. Thank you for shopping Wal-Mart."

Then inexplicably, all the customers abandon their loaded carts and flood out of the store. Then the store manager, coming to his senses, turns on the loudspeakers in the parking lot and announces: "Ladies and gentlemen, we apologize for our mistake. If you will return to the store, all merchandise will be offered at 10% higher prices than before you left."

At this point, all the customers hastily re-park their cars and re-enter the store. Then they begin ripping merchandise off the shelves at a much more feverish pace than they previously had. All was now good in Wal-Mart land.

Obviously, sane Wal-Mart shoppers would never behave in such an irrational way. When perfectly good merchandise went on sale, they would become more motivated buyers. The stock market is the only market on earth where shoppers flee the store when the merchandise goes on sale.

Volatility Is Not Risk

In the investing world, much is written about volatility. Many even consider volatility to be synonymous with risk. In our view, the risk is not the volatility; rather it's the reaction to volatility where true risk resides. If I am not planning to buy or sell today, then today's volatility does not, or at least should not, concern me. I know that in the long run operating performance is what matters most. I am better served focusing on how the businesses I own are performing. The metaphor above is in our view more than a clever story. Behavioral psychologists have recently pointed out that investors feel the pain of loss, two-and-a-half times greater than they do the pleasure of gain.

Over short periods of time, fear and/or greed will dominate the trading behavior of investors in financial markets. Emotion really doesn't belong in investment analysis. However, the emotion "fear" is the most dangerous of the two. In either case, when emotion rules, investors tend to behave in an opposite manner, as to the way they should behave.

Valuation Matters

The great advantage of the EDMP, Inc. F.A.S.T. Graphs is that they illuminate the importance of valuation as it relates to earnings. In the long run earnings determine market price. In the short run, the two can become temporarily disconnected, however, inevitably price will return to its earnings justified level. Therefore, when trying to determine the future value or movement of a stock or a market, it's wise to measure valuation relative to earnings. Again, at the end of the day, this is what matters most.

A point of logic supporting this principle is the notion that it's easier to forecast, within a reasonable degree of accuracy, the prospects of a business than it is the short-term movement of an often emotionally charged crowd called "The Market". Emotional reactions are very unpredictable and subject to wide swings, in markets this is known as volatility. On the other hand, fundamentals change very little over short periods. Therefore, focusing on the zigzagging price ball takes your eye off of the critical intrinsic value ball where it belongs.

Be Greedy When Others Are Fearful

The legendary Warren Buffett has offered investors many gems of wisdom over the years. Two of my favorites that apply to this writing are: 1. " Be greedy when others are fearful, and be fearful when others are greedy ", and 2. " Fear is the foe of the faddist, but the friend of the fundamentalist ." The moral of these gems is to keep emotion in check when making investing decisions.

Figure 2 below re-visits Figure 1 above, with emphasis added for clarity. The red shaded area highlights how overvalued stocks became during the irrational exuberant period. Recognize that the green earnings line with the white triangles represents the normal PE of 15 for the S&P 500, and is where true worth valuation resides. Therefore, this was a clear and evident time to be fearful as others were greedy. Stock values had no rational place to go except down at the greed peak of calendar year 2000.

The yellow shaded area depicts a time when fundamentals (earnings) were collapsing. Here, stock prices followed earnings down, and were behaving rationally based on fundamentals. Of course, as we all remember, fear became quite manifest. The orange arrow points to October of 2008 when Warren Buffett wrote his famous " Buy American. I Am. ", article for the New York Times. Yes, he was a little early, but a good time to be greedy while others were fearful nevertheless. Also, it's clear that price moves to where earnings are going, and earnings are going up today.

Figure 2: S&P 500 15yr EPS Growth Correlated to Price (with emphasis)
Figure 2: S&P 500 15yr EPS Growth Correlated to Price (with emphasis)

Conclusion

If we are to invest successfully, we need to place our attention on what matters most and keep a level head. Years of research have led us to conclude that earnings matter most and are the most reliable predictor of future movements. Spend some time studying Figure 1 or 2 and this point becomes self evident.

Standard & Poor's on their " Earnings and Estimate Report " dated May 19, 2010 make the following statement: " With 97% of Q1 reported, earnings are posting a 12.5% positive earnings surprise, with strong GAAP numbers; initial cash-flow good …" On this same report they estimate S&P 500 operating earnings of $81.62, up 4.57% from their March 31, 2010 estimate of $78.05.

Michael Santoli authored the Barron's Cover | Saturday, May 15, 2010, titled " Stronger Than Ever ". The basic premise of this article is that Corporate America is fiscally as fit as ever. Trends Magazine offered a multi-part series in their April & May 2010 issues titled respectively " A New Golden Age.. . When people least expect it " and " Accelerating Innovation and the New Technology Boom ." These are just a few examples of encouraging information that imply future business growth.

Our point is not to be Pollyanna. We don't covet that view any more than we do the doom and gloom perspective. Instead, our objective is to realistically evaluate the future based on the most reliable prognostication tools available. If earnings do manifest as forecast above, then future S&P 500 stock values will go higher long term.

In our experience there is a preponderance of conclusive and undeniable evidence which supports the functional relationship and strong correlation between earnings and price. We believe in keeping emotion out of the equation. Therefore, our focus is on actual earnings as reported, coupled with reasonable forecasts going forward.

Neither hype nor hysteria is participated in here. The stock market will surely experience bouts of volatility, but eventually earnings will drive the direction and level of price action. Therefore, we advise investors to watch their earnings closely and always keep their perspectives rational.

Disclosure: No position in the S&P 500 index.

The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

See also Systemic Risk: High in Europe, Not So Bad in the U.S. on seekingalpha.com



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , US Markets

Referenced Stocks: DIA , QQQ , SPX , SPY , WMT

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