We just completed one of the best Julys in history with the S&P 500 up 7.56%. The reason? Earnings. It’s all about earnings. By and large, companies have reported earnings that have been far better than expected.
Many in the mass media have been fretting about the fact that while earnings are indeed better than expected, they still are not really good on an absolute basis. Worse still, many companies reported improved earnings just because of cost reductions, not increased revenue. What these commentators don’t seem to understand is that there are two factors that lead to the overall level of the market: the first is earnings, and the second is price.
The value of a stock is the present value of future earnings, and the current market price reflects the consensus opinion of what those future earnings are going to be. The price changes when the opinion of the future changes. This is why the best companies are not usually the best investments – the best companies are already expected to be great, therefore their greatness is already priced into the stock and although they may continue to do extremely well, their stock price is unlikely to increase greatly.
The real question investors should be asking is not how good are earnings going to be, but are earnings going to be better or worse than expected. That is what moves the market.
While we are growing more cautious ourselves, this negative spin on the market movement among the mass media is actually a sign to us that this rally may continue a bit longer. After all, the lower the expectations, the easier they are to beat.
Chuck Osborne, CFA