Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
The great economist Keynes likened stock market investing to a newspaper competition in which contestants are asked to pick the six most attractive faces from a hundred photographs.
In this contest, the naive strategy is to focus on the faces you find attractive. A more sophisticated approach is to consider what society generally perceives to be attractive and to use that as the basis of your choices.
A yet more complicated strategy is to think about what other contestants might understand the popular perception of attractiveness to be. The challenge is not to find the most attractive faces but to second guess the most popular choices of all the people taking part.
Keynes thought stock market investing was similar because to some extent shares are not priced just on their fundamental merits but also according to shifts in market sentiment. What’s in fashion today and, indeed, what investors think will be in fashion tomorrow. And the price they are prepared to pay to take part.
A year into a remarkable bull market for shares, investors face a related challenge. There is clearly lots of good news around. But to what extent have analysts really understood the extent of companies’ improving prospects? And how much have other investors already priced that good news into valuations today?
Today’s first quarter figures to the 1 May from clothes retailer Next are an illustration of the good news in the market today. Sales in the three weeks since shops re-opened on 12 April have been significantly better than forecast and, as a result, sales in the 13-week period were down just 0.6% compared with the same pre-pandemic period in 2019. That compares with the 10% fall that the company had expected. As a result, Next upgraded its profit forecast for the full year to January 2022 by £20m to £720m.
Next’s figures are just one example of a compelling trend on both sides of the Atlantic. With about 60% of S&P 500 companies having now reported their first quarter earnings, more than 80% of results have come in better than expected. It’s the same story over here where growth in earnings has been around 15 percentage points better than expected, the best result since the recovery from the financial crisis.
Because companies try to manage analysts’ expectations ahead of earnings announcements, there are usually upgrades to forecasts as earnings season progresses. But this year has been exceptional in that regard. At the start of the first quarter reporting period, analysts had pencilled in earnings growth of 24% in the US. Now this is expected to be 46%. The experts have basically ripped up their previous forecasts and started again.
This matters because it goes a long way to justifying the recent strength in stock markets around the world, which are pushing on to new highs as expectations about the recovery improve.
Morgan Stanley, the investment bank, recently analysed investors’ enthusiasm for shares using a measure of the extra return that investors are effectively demanding from shares when compared with less risky investments like government bonds. In the jargon, the measure is called the ‘equity risk premium’.
To calculate it, the bank compares company earnings with share prices to create an ‘earnings yield’ that can be measured against the yield that we are more familiar with on a benchmark bond like the US 10-year Treasury bond. It’s the inverse of the traditional Price to Earnings (P/E) ratio that many investors are already used to.
According to Morgan Stanley, shares are more expensive on this measure than at any point in the past 13 years, although not as expensive as they were before the financial crisis and, particularly, around the time of the dot.com bubble in 2000.
Comparing that earnings yield with inflation expectations, a reasonable hurdle for investors to want to exceed, shares are more expensive than they have been since that market peak more than 20 years ago.
So, what does this mean for investors today? It means that while there is lots of good news out there, it needs to keep flowing to justify market levels today. If companies like Next continue to upgrade their internal estimates, and if analysts follow suit and keep increasing their forecasts too, then shares merit today’s valuations. But we should understand that the bar has been raised quite high now.
The faces in the paper may be attractive still. What matters is that the other contestants continue to agree.
Price to Earnings (P/E): A valuation ratio of a company's current share price compared to its per-share earnings.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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