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This article first appeared in the Telegraph
THE arithmetic of the stock market is not complicated. A share price has two components. The first is how much profit a company makes divided by all the shares it has issued. This profit per share is influenced by various factors - the health of the economy, how good a company’s management is, changing customer tastes, whether costs are rising or falling, sometimes just good or bad luck.
The second part of the equation is how much an investor is prepared to pay for those profits. This also goes up and down according to the ebb and flow of investor sentiment. When the outlook is bright, investors will be prepared to pay more for the same amount of profit; when they are pessimistic, they will pay less.
If investors believe that a company’s earnings are going to grow quickly, they will generally be prepared to pay a higher multiple of those earnings to own its shares. If profits are going nowhere, they won’t.
Share prices move around so much because they are the product of these two variable factors. If you time it right, you can benefit from both rising earnings and an increasing valuation multiple. Get it wrong and you can be caught out by falling profits and a simultaneous drop in the valuation multiple. Knowing where earnings are headed is part of the challenge. Deciding the right price to pay for them is another, and just as important.
Four times a year, investors get the chance to measure their assessment of these two factors against reality. Earnings season is when every company opens its books to anyone who cares to look and the latest instalment, focused on the three months from January to March, has just begun. Or at any rate the earnings season which garners the most attention, the results of the 500 companies making up the US’s S&P 500 index.
Last week, this first quarter earnings season began, as it always does, with a string of results announcements from the big Wall Street banks like Goldman Sachs and JP Morgan which pride themselves on getting their numbers together quicker than anyone else. This week another 70 or so big American companies follow suit with a broader set of industries under the spotlight. The latest batch has included results from Tesla, American Airlines and Netflix, the last of which has provided a timely illustration of what happens when earnings and sentiment go the wrong way at the same time.
Over the next two weeks a further 330 or so of America’s top 500 companies will report. It’s really impossible for anyone to keep up with the blizzard of announcements so it’s the general themes that matter and even more importantly what companies have to say about the outlook. Stock markets care more about what’s going to happen than what just has.
The challenge for both companies and their investors is that on several fronts there is more uncertainty than usual. A cocktail of rising input costs, higher wages, rising mortgage costs and wobbly consumer demand mean the range of possible outcomes is wider than usual. As it stands, analysts expect earnings to grow by around 5% in the first quarter and by perhaps twice as much for the year as a whole (as the comparisons get easier). But growth could be much higher or lower than that.
Another complicating factor in the latest season is the extent to which results are being distorted by surging oil and gas prices in the first three months of the year. The cost of Brent crude is up by a third in the year to date, which is great news if you are an oil company but the opposite if you are a big user of energy.
Credit Suisse thinks that the earnings of energy stocks will be a massive 240% higher in the three months under review than they were a year ago. That’s because pretty much all the rise in the selling price of their product drops through to the bottom line. They have relatively fixed costs. Other big winners this time will be materials companies, on the back of soaring commodity prices, and industrials.
Offsetting these buoyant sectors will be financials, which enjoyed lots of profitable work a year ago, but this year are struggling with a narrow gap between the interest rates at which they borrow and lend. Consumer discretionary firms are also looking at declining profits, in large part due to weak car sales as the supply of computer chips has dried up.
So, the outlook for earnings is mixed, but in aggregate modestly positive. Which brings us to the second part of the share price equation. How much should investors be paying for those earnings? And this is where it gets tricky. Because while paying about 19 times this year’s earnings might make sense when profits are rising and interest rates are low, it leaves less margin for error when earnings growth is slowing and interest rates are going up.
The good news is that the multiple of earnings has been reducing for a year or so because investors have not been oblivious to what’s going on. The bad news is that history suggests it might have to fall a bit further before it represents fair value. Let’s say that investors decide they only want to pay 17 times earnings rather than 19. All other things being equal, earnings will need to rise by about 10% just to make good the difference.
And this explains why stock markets are in the doldrums right now. Shares are caught between two opposing forces - modestly rising earnings but a dwindling appetite to pay up for a share of those profits. How this two-way pull resolves itself will be determined in large part by the numbers released over the next couple of weeks and even more so by the comments that accompany them.
Watch Tom Stevenson’s outlook for the US over the next quarter
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. 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 one of Fidelity’s advisers or an authorised financial adviser of your choice.
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