Until just recently, stock market volatility had been exceptionally low, leading many to believe that this market had become “complacent.” That assessment elicits concern because of many view complacency as a warning signal … a calm before the inevitable storm.
Well … as Hyman Minsky taught us, that storm will come, and in many ways, it will be a direct result of our complacency. But right now, US equity investors seem to be anything but.
If you’ve been wondering how stocks can continue to rise, day after day, week after week, in the face of a stalled US political environment, confrontation with N. Korea and lukewarm global growth, take a look at the chart below.
As you can see, it’s earnings growth that has been pushing this market higher. The last four quarters have seen an acceleration in earnings growth, with the two most recent quarters outpacing the growth rates seen earlier in this expansion.
You simply will not see earnings growth like this take place without a significant response in asset prices. But that, in and of itself, does not suggest that the market isn’t complacent, so what does?
Answer: The investor response toward companies that do not meet or surpass their profit expectations.
In investing, the term “participation” is frequently used to refer to what proportion of the market is taking place in a given move. When participation is at either extreme (either very low or very high), it can be a warning signal for investors.
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For example, when major averages are setting new highs, we frequently monitor market breadth to ensure that a large swath of the market is heading higher alongside the averages. If market breadth is weak (there is little participation in the rally), it’s a sign that the advance is not on solid footing and that the market may be reaching a point of exhaustion.
On the other hand, when participation becomes too strong, and every single stock is advancing in harmony, this too becomes a warning sign. In this case, the concern is about complacency. When nearly all stocks are advancing, it can represent indiscriminate buying, which sows the seeds of a future decline.
So, what we really want to see on an advance is healthy participation, combined with evidence that investors are still looking closely at companies on a stock by stock basis. Let’s explore these two factors in more detail.
First, here’s a look at the advancing vs. declining issues on the NYSE. While this index just dropped below its 50-day moving average, it has been repeatedly setting new all-time highs in sync with the major averages. This tells us that the action we’re seeing in the averages is representative of the overall market … a good sign.
Next, we’d like to identify whether complacency has crept into the market by looking at how investors are treating stocks on a case by case basis. One way to do that is to look at the responses companies are seeing based on whether they hit or miss their earnings targets.
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Bespoke Investment Group has done a lot of the number crunching for us, and we can see the results in the chart below.
As you can see, stocks that are beating their earnings estimates are receiving a little boost to their share price, while those that miss are getting pummeled. What does this mean?
There are two main takeaways here in my opinion, and both tell different stories about the state of the equity markets.
When companies beat their estimates, raise future guidance, and their share prices barely budge higher, it’s a sign that valuation levels are already elevated. But you already knew that, because we’ve been saying so for years … yes, years now.
But you also know (or at least you should), that bull markets never end on valuation concerns. Rather, they end when the best that can be seen ahead is fully discounted in the stock market, and a recession (either U.S or global) is on our doorstep. So while high valuation levels should make you cautious, it’s not a valid reason to completely exit the stock market.
On the other hand, companies getting severely punished for missing estimates should make you smile. Why? Because it’s a sign that investors are not being complacent. Instead of saying, “well … we have a good macroeconomic backdrop so earnings should rebound moving forward,” they’re saying, “you screwed up, you deserve to be punished, your stock is not worth what we previously thought.”
That’s a good sign, as it implies that investors are still factoring in fundamentals and not getting carried away by herd mentality and group think. Yes, there is certainly some of that going on, as there always is, but it doesn’t seem to be rampant.
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According to Bespoke, companies that have missed earnings so far, this season has seen their share prices fall by an average of 3.4% that day. That’s a significant drop, especially when you consider that the overall market has remained in an uptrend.
Moving forward, the strong earnings that we’re seeing now can and likely will come back to haunt us. This is because earnings growth is typically measured on a year-over-year basis.
If you look at the first chart in this article, you’ll notice that prior to the most recent four-quarters of strong earnings growth, we had four straight quarters of declining earnings growth. What this did was create a low bar for earnings to surpass one year later (now).
When we see weak earnings in a particular quarter, it sets the stage for possible blowout figures the following year, because of the low hurdle. In contrast, when we see extremely strong profit growth, it’s great for the moment, but signals that profit growth next year will be more difficult to achieve.
And of course, if profit growth declines a year from now, or heaven forbid turns negative, we’ll see corresponding weakness in asset prices. So in a way, exceptionally strong profits can actually sow the seeds of a future demise.
Now that corporate profits are back to record levels, it means that the bar is once again high, and more companies will be at risk for falling short. This means that come next year, we could be having a completely different conversation.
But for now, with earnings growth remaining strong, and next year’s results too far away to accurately discount, market conditions remain favorable. Therefore, stay with your positions as this bull continues to take the escalator higher.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe. Matt is also the Chief Investment Strategist at Model Investing. For more information about algorithmic based portfolio management, click here.
