The trouble with forecasting markets is that there are so many variables, often moving in opposing directions. How do we know how much weight to put on each one?
There is no correct answer to that question, except of course in hindsight. But unfortunately hindsight doesn't provide us a viable way of investing.
At a fundamental level, when we buy shares of a company or a group of companies, our ownership interest represents a share of future profits. The higher those future profits are, the more we should be willing to pay for a share of those profits.
Common valuation methods use this exact concept. For example a discounted cash flow (DCF) model looks at projections of future profits to determine how much a company is worth today. A basic DCF analysis operates on the idea that a company's value is equivalent to the amount of cash it can make available to investors in the future.
I have many friends and colleagues who constantly express disgust at how this so called economic recovery doesn't feel like a recovery. Their personal experience doesn't yield any indication that the economy is healing, that jobs are being created, that household net worth is growing and has reached new record levels. To them, things just don't feel right. So they look at this bull market as a phony representation of the economy, just another manipulated feature of this world where nothing can be trusted.
I sympathize with that view, but when it comes to the stock market, there are some justifications for the level we are at. My first response to those who don't believe we've had any type of recovery, or that the stock market shouldn't be this high, is to bring up corporate profits.
As I alluded to above, corporate profits are the lens through which most variables should be filtered to determine their impact on stock prices.
Want to know why the stock market is still sitting near record levels with everything that's going awry across the globe? The answer is because corporate profits are at record levels. We could argue all day long about whether corporate profits should be at record levels, but at the end of the day that doesn't really matter.
Here is a chart of corporate profits through the second quarter of 2014. The minor dip you see at the far right represents the Q1 weather induced slowdown. But Q2 profits came in very strong, and we'll soon start to see companies report Q3 earnings.
Corporate profits have a history of peaking before the stock market, and by a fairly wide margin. The 2007 market peak came more than a year after corporate profits peaked in Q3 2006. The 2000 market peak experienced an even longer delay; corporate profits peaked in Q3 1997, but the S&P 500 didn't peak until Q1 2000.
So history would suggest that we have not yet seen the top of this bull market, and may not see it for some time. Even if Q2 2014 turned out to be the peak in corporate profits (I highly doubt that to be the case), we could see the market run for another year or two. And if corporate profits do keep heading higher, expect this market to ratchet up in sync.
This upcoming earnings season may be one of the most interesting we've seen in awhile. That's because everyone is trying to get a read on global growth. Economic reports help paint part of the picture, but reports from companies with boots on the ground, who are actually navigating the headwinds, will tell us a lot about where things stand.
As is typically the case, less emphasis will be placed on actual reported earnings, and more on forward guidance.
We can also expect a lot of stock-by-stock volatility, as each company sinks or swims based on individual performance and their exposure to various crosscurrents. As a general rule of thumb, the companies that will probably put up the best numbers and outlooks are those with a primarily domestic market (unaffected by foreign developments and the strength of the dollar), those that are typically commodity buyers (think retail), and those who have somewhat secular rather than cyclical growth prospects.
The above content was an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
Related:
Corporate Profits and Market Peaks – Are We There Yet?
