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Back to Basics

By Richard April 11, 2018 Market Watch

The last commentary has been left on the site as the most recent for longer than usual.  This is not because of neglect, but because it continues to be an appropriate commentary and timely even still.  That last commentary was about market corrections.  Investors were encouraged to stick to their overall strategy, knowing that corrections are a normal part of market activity.  It was noted that, “When corrections are in the process of coming to an end, markets may often be very volatile.”  This has certainly been the case since that commentary was posted.  Corrections can be nerve racking, but the wise investor often finds opportunity in the corrections.

Why is this likely a correction and not a longer-term market reversal leading to an extended period of declining stock markets?  There is the “technical action” of the markets that seem to indicate this is a normal correction.  More than that though, are the basics, or fundamentals, of the current situation.  So, what are some of the basics?

On the smaller scale, there is the individual company.  Corporate earnings seem to be growing.  First quarter earnings will soon begin to be reported.  As analysts continue to revise their earnings forecasts, it would seem at this time that the majority of revisions are for higher earnings.  One of the most important components that determines a stock’s price is the earnings of the company.  In general, when earnings increase for a company, the stock of the company tends to increase in per share value.

On a larger scale, there is the overall economy that provides the backdrop environment that leads to either corporate earnings growth or contraction.  The economic data continues to come in very strong.  Indeed, some of the economic numbers are the strongest in history.  For example, the “Unemployment Rate – Black or African American” has seen a dramatic decline.  ( )  This has been a very hard economic issue to conquer over the past decade, but the decline is very encouraging and would seem to be indicative of the overall health and improvement in the economy.  Overall, employment data seems to indicate a strong and growing jobs market with an unemployment rate at 4.1% ( ).  There appears to be a trend of increasing inwages paid ( )  This should lead to further consumer spending and to increasing corporate earnings.  One of the broadest measures of how the economy is doing is the Gross Domestic Product (“GDP”).  The current read is that GDP is growing at 2.9%.  ( ).

Another larger scale indicator is the business cycle.  The four phases of the economic business cycle are:  expansion, peak, contraction and trough.  The economy peaks at some point and then begins to contract and that is called a recession.  Given all the positive economic data, it would seem to indicate that the economy is still in the expansion phase.  During the expansion phase, companies tend to sell more and more products and that leads to better earnings usually.  A peak and the following contraction (“recession”) are usually preceded by a variety of indicators, none of which seem to be indicating a peak or a looming contraction at this time.

The tax law recently enacted provides another positive for corporate earnings.  Some estimates are that the tax law will add about 8% to earnings in 2018 for the S&P 500 companies on average.  Theoretically, were 2018 to see no earnings growth whatsoever other than the tax law’s impact, the S&P 500 should be expected to go up in value about 8%.  The tax law, though, is spurring activity and GDP growth that should lead to earnings growth even beyond the base 8%. 

The stock market should be expected to follow, at least directionally over time, corporate earnings.  Should earnings expectations be met or exceeded in this next earnings cycle, which may prove to be what finally ends the correction phase of the markets we are currently experiencing. 

Investors should do well to remember, too, that the point swings on the Dow Jones Industrial Average reported nightly on the news should really be seen in percentage terms.  The points seem a lot scarier because they are seemingly so large compared to what they have been in the past.  When the DOW was at 10,000, a point swing of 100 was a 1% drop and 500 points would be a 5% decline.  With the current level of the DOW it takes about 240 points or more to equal a 1% move, while a 500 point move is only about a 2% move.  Additionally, in extremely volatile periods, like during a correction phase, it is often helpful to add point swings together for several days:  up 400 points today and down 500 points tomorrow is a move of only 100 points over the two days.

As always, we encourage our clients, and investors in general, to have a strategy, know why that is the strategy chosen and stick to it.  The knowing why the strategy is the one I place should go a long way in helping to ease nerves when things turn volatile.  Focusing also on the basics helps to reduce focusing on all the day-to-day noise and, instead, see the real trends that are at work.