Only three things matter for stock prices
Friday, 20 September 2019
By Greg Canavan
- Company Earnings
- Government bond yields
- Investor sentiment
Hi, Greg Canavan here.
You’re regular editor Bernd Struben is off today. He’s handed the reins over to me for the day.
Given the craziness going on in markets right now…what with stocks rallying near multiyear highs in the face of a global downturn…I thought I’d republish an essay I wrote for Crisis & Opportunity subscribers a few weeks ago. I have just updated the charts to yesterday’s close.
Hopefully it will rationalise some of the market strangeness you’ve been seeing lately.
The stock market can often seem like a hugely complex beast.
Today, I’m going to make it really simple for you. If you’re interested in how the stock market works, you’re going to like this essay.
There are only three things that drive the share market on a day-to-day, or year-to-year basis:
- Company earnings,
- Government (or ‘risk free’) interest rates, and;
- Investor sentiment.
Company earnings are perhaps the most important of the three, as they provide a fundamental basis for assessing a stock, or the overall health of the stock market.
Interest rates provide another important foundation for stock valuation, while investor sentiment is influenced by a million different factors. But all those factors coalesce into a price, which we can see in a chart.
Before we go any further, let’s take a look at the markets…
Overnight, the Dow Jones Industrial Average closed down 52.29 points, or 0.19%.
The S&P 500 closed up 0.06 points, or 0.002%.
In Europe the Euro Stoxx 50 index closed up 24.61 points, or 0.7%. Meanwhile, the FTSE 100 rose 0.58% and Germany’s DAX closed up 68.08 points, or 0.55%.
In Asian markets Japan’s Nikkei 225 was up 74.65 points, or 0.34%. China’s CSI 300 was up 0.23%.
In Australia, the S&P/ASX 200 is up 27.20, or 0.40%.
Oil lost a bit of its lustre following the drone strike in Saudi Arabia.
West Texas Intermediate crude oil is US$58.62 per barrel. Brent crude is US$64.66 per barrel.
Turning to gold, the yellow metal is trading for US$1504.90 (AU$2,214.84) per troy ounce. Silver is US$17.88 (AU$26.31) per troy ounce.
One bitcoin is worth US$10,218.56.
The Aussie dollar is worth 67.94 US cents.
Earnings season in Australia has just wrapped up, so let’s kick off with that first…
To put it bluntly, it wasn’t good.
In fact, it was the worst reporting season since 2012, or 2009, depending on the measure used.
The Sydney Morning Herald reported on 30 August:
‘Shane Oliver, the head of investment strategy and chief economist at AMP Capital, described the earnings season as “pretty soft”, pointing to the ratio of companies that beat their earnings expectations to those who missed as one clear measure.
‘“Only 36 per cent of companies have surprised on the upside on earnings, which is the worst result since 2012,” Mr Oliver said. “[While] 37 per cent have surprised on the downside, so there’s been slightly more downside than upside surprises. That’s a pretty weak outcome.”’
Importantly, the results and surrounding commentary had a negative impact on future profit expectations, as well. This commentary is from The Australian on 6 September:
‘Earnings revisions were very weak — a 1.9 per cent downgrade of the consensus estimate of aggregate earnings per share for the year ahead marking the biggest fall in any month since January 2016, when global recession fears peaked amid a slump in oil prices and China’s sharemarket.
‘The average downgrade of expected earnings per share during results seasons is about 0.8 per cent, making the 1.9 per cent fall this August worse than normal. Moreover it marked a change from the recent pattern, given that the last five results seasons saw a net upgrade of the consensus EPS estimate.
‘“There have been more months more recently than 2009 when downgrades were bigger due to geopolitical issues and global drawdowns, but if we concentrate on the results months of February and August, the last time we had a greater reduction in earnings estimates than this was in the middle of the GFC,” Steed said.
‘Furthermore, the breadth of net downgrades in the top 300 companies rose to almost 70 per cent, the most in well over five years. “What’s really stunned me is the magnitude and breadth of the downgrades,” Steed said.
‘“Breadth is the one that really bothers me. The Australian market can be overwhelmed by materials or financials, but the proportion of downgrades versus upgrades across the ASX300 is quite startling.’
While earnings growth — and expectations for future growth — was the worst in years, the broader Aussie stock market is still trending higher!
As you can see in the below chart of the ASX 200, the August correction saw prices fall back to the 100-day moving average. However, if we view the moving averages as a rough proxy for the medium term trend, then you’d have to say the trend is still positive!
Click to enlarge
That doesn’t mean it will stay this way. As I’ve been saying over the past few months, I believe the market is topping out. A ‘lower high’ here on the chart would be additional evidence of that view. From there, you’d want to see the August low taken out.
But right now, the market isn’t confirming my bearish view. So we have to keep an open mind and ask whether we are wrong.
Government bond yields
Which brings me to point two: The government bond yield, often referred to as the ‘risk free rate’.
The gist here is that an investor can buy government bonds and be all but guaranteed they will get their money back at maturity. The risk of outright capital loss is tiny.
The long term government bond yield then (usually the 10-year yield) is an important barometer for valuing other, ‘riskier’ assets.
For example, if the 10-year bond yield is 5%, you would want something like an 8–10% return from shares to compensate you for the increased risk.
In very basic valuation terms, for a company earning a profit of $10 million, the investor looking for an 8–10% return would pay between $125 million and $100 million. (You get this by simply dividing the profit by the required return.)
Now look at the chart below. While the Australian government 10-year bond yield has been trending lower for years, at the start of 2019 is spiked down to all-time lows. The yield is currently around 1%.
Source: RBA Chart Pack
Click to enlarge
If this is now the ‘risk-free rate’, then perhaps share investors think 5% is a decent, risk adjusted return now?
Our company with a $10 million profit, all of a sudden has a valuation of $200 million under such a scenario ($10 million/0.05). Even if earnings fall to $9 million, the company valuation would still be $180 million using a 5% required return.
Can you see how lower interest rates provide a big boost to markets, even though earnings might be under pressure?
Clearly, right now, the effect of lower interest rates is having a more powerful impact than the poor earnings season that just passed.
How long this continues all depends on the third factor driving share prices — investor sentiment.
Sentiment is obviously impacted by tangible things like earnings and interest rates, as well as a thousand intangible factors.
This is why analysing the charts is so important. The charts contain all the tangible and intangible factors that influence a share price. Earnings, interest rates and investor sentiment, are all captured in the chart.
If you have a look at the chart of the ASX 200 again, you’ll notice that the moving averages are starting to flatten out. This could either be a pause in the upward trend, or the start of a change in trend from bullish to bearish.
The flattening out — to me at least — represents the push and pull from weaker earnings and lower interest rates, as well as bullish sentiment from earlier in the year starting to wane.
The market is confused. In my view, this reflects a shift from a bull to a bear phase. These turning points can often last for months, especially when the authorities are actively trying to prevent the bear from emerging.
But the market hasn’t yet confirmed this view.
What do you need to see for increased confirmation?
Keep an eye out for the 6,400 level on the ASX 200. A break below there will put us one step closer to entering into a bear market phase. Should that happen, it could see stocks fall 20–30% within six months.