403 Years is a Long Time to Wait to Earn a Profit on a Stock…

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This should worry a few investors:

Amid the normal consensus of bullish calls for stocks in 2016, evidence is mounting that Wall Street strategists are losing their resolve as everything from China to oil and interest rates roil markets.

Just five weeks into 2016, seven of the 21 strategists tracked by Bloomberg have lowered their projections for the Standard & Poor’s 500 Index amid a rout that wiped more than $2 trillion from prices. The cuts have reduced the average annual estimate, the first time that’s happened this early in a year since the Iraq war in 2003.

It’s about time Wall Street analysts reined in their price targets for the S&P 500.

But here’s the important thing. These strategists generally don’t just make up numbers.

They set a price target for the index based on calculations for earnings for companies that make up the index.

This is something we’ve highlighted for several months. It’s the disconnect between price forecasts and earnings forecasts.

Think back to what we’ve told you before. We’ve long explained that two things move stock prices: interest rates and earnings.

If investors have a positive outlook for earnings, they’ll pay a higher price for a stock today, because they believe earnings will rise, justifying a higher stock price in the future.

If investors have a negative outlook for earnings, they’ll only pay a lower price for a stock today, because they believe earnings will fall, not justifying a higher stock price in the future.

That’s what should make this chart so troubling for investors:



Source: Bloomberg

Click to enlarge

Everything to the left of the green line shows you actual earnings for stocks that make up the US S&P 500 index. You can see a clear rise in the trend from the low point in 2009.

But then, at the point indicated by the red arrow, you can see that the upward trend begins to break down.

In fact, from that point on, earnings begin to plateau and then fall slightly.

Yet, look at the line to the right of the green line. This indicates analysts’ future earnings estimates for S&P 500 stocks. Something isn’t right.

The trend of real earnings is falling, yet Wall Street is still forecasting rising earnings. To put this in perspective, in order for real earnings to match Wall Street’s estimates, earnings will have to increase by nearly 10%.

Considering the average annual increase has only been 4.2% over the past three years, that seems unlikely.

The last time earnings increased to such a degree was in 2009 and 2010, as the global economy bounced back from the financial meltdown. Back then, the markets had trillions of dollars of freshly printed money washing around the system too.

Of course, the printed money is still in the system, it’s just that printing money no longer has the huge impact that it did in 2009 and 2010.

This relationship between earnings estimates and earnings reality is worth watching closely. As the Bloomberg report shows, even Wall Street is beginning to doubt the forecast growth.

But so far, only one-third of the analysts have changed their tune. The big turn for the market will only come when another third realise that their forecasts are a long way from reality.

Who can wait that long?

It hasn’t been a good start to the year for Amazon.com.

So it’s not just resources stocks taking a beating. Online retailing stocks are taking a rap over the knuckles too.

Since the start of the year, Amazon.com’s stock price has fallen 25.7%.

It just goes to show that earnings do matter. By the way, the chart below isn’t a chart of the company’s stock price. It’s a chart of the company’s price to earnings ratio (PE).



Source: Bloomberg

Click to enlarge

If I didn’t know better, I’d say that chart was ‘flipping the bird’ to investors!

As recently as five weeks ago, Amazon.com traded on a PE ratio of 500-times earnings. After the big price drop on Friday night, it’s ‘only’ trading on a PE of 403-times.

Bargain.

As I say, earnings do matter. Now, investors cop a lot of grief for not thinking far enough into the future. Wall Street and politicians like to say that investors only think about today, or tomorrow if you’re lucky.

But even Wall Street must admit that a PE ratio of 403 for a mature business is stretching long-term thinking a little far.

Think about what a PE of that size means. It means, that if you invest in the company today, based on its current earnings, it would take you 403 years to ‘earn back’ your investment.

We know that medical science is coming along leaps and bounds, and that the population is ageing, even so, asking someone to wait 403 years to ‘earn back’ their investment is a long, long time.

Expressed a different way, if we consider the earnings yield of Amazon.com just as we may look at a dividend yield, then Amazon.com is earning its shareholders just 0.24% per year.

No wonder the company doesn’t pay a dividend. Even if it paid out 100% of all earnings, you still wouldn’t get a yield above one quarter of one percent.

Amazon.com wasn’t the only online stock to take a hit. LinkedIn Corporation [NASDAQ:LNKD] fared even worse. Its stock price fell 43%.

According to the report from Reuters:

The stock sank to a three-year low of $108.38, registering its sharpest decline since the company’s well-publicized public listing in 2011. LinkedIn’s full-year revenue estimate of $3.60 billion to $3.65 billion was below the average analyst estimate of $3.91 billion…

You could say that the market over-reacted. After all, the company’s earnings forecast is only 10% below analyst estimates…yet the stock fell 43%.

But that’s what investors do. Remember that the analysts’ estimate is an average. There are many investors who bought the stock because they expected earnings to grow 10%, 20%, 30% or more.

Some analysts had target prices of US$280 and even US$310 on the stock price. Earlier this week it was at US$108, and it has a long way to go to get anywhere near those price targets.

The beginning?

This market reaction to the LinkedIn earnings forecast could be repeated across the entire market if one company after another disappoints investors and analysts.

Remember the chart I showed you at the top. Most analysts still believe US companies can grow earnings at an average of 10% next quarter — not next year, but next quarter!

That isn’t going to happen. In which case, what does that mean for stocks?

An overly rosy picture

Speaking of overly rosy estimates, check out this composite chart from Bloomberg. The blue line shows historical Australian GDP growth. The pink line shows the Reserve Bank of Australia’s (RBA) estimates for GDP through to 2018:



Source: Bloomberg

Click to enlarge

It’s a nice bit of extrapolation of data by the RBA.

Although, we could argue that they’re taking a bit of a liberty when it comes to picking trends. The RBA could very well be right.

The economic dip in 2015 may have been the low point. From here on in it could be that the Aussie economy continues to recover, and enjoys a new dawn as a non-resources economy.

Or…the RBA could have gotten it completely wrong, and the trend that has formed since 2012 could continue, as the economy splutters and belches to a recession in 2016.

Ignoring the talking heads

The markets are addictive. There’s always something going on.

And yet, does it really matter to an Aussie investor what happens to the earnings and stock prices of Amazon.com and LinkedIn?

You could argue that it doesn’t. We’re pretty sure that’s the angle Quant Trader, Jason McIntosh would take.

He’d tell you not to worry about all the market ‘noise’, and instead just focus on what the price action is telling you.

That’s the beauty of Quant Trader. It filters out the noise. It just leaves you with the trade idea, how to get into it, how to get out of it, and nothing else.

That’s because nothing else matters.

OK, I’m being a bit flippant there. Other things do matter, such as position sizing, cutting losers, letting winners run, and all that stuff.

But the point is that Jason McIntosh has shown his subscribers that there are ways to potentially make money in the markets, regardless of the market direction, and regardless of what the talking heads (like me) rave on about each day.

If you haven’t looked at Quant Trader yet, you can do so here. It’s worth checking out.

Cheers,
Kris

Kris Sayce
Kris Sayce, dubbed the ‘Jeremy Clarkson of Australian finance’, began as a London finance broker specialising in small-cap stock analysis on London’s Alternative Investment Market (AIM). Kris then spent several years at one of Australia's leading wealth management firms. A fully accredited advisor in shares, options, warrants and foreign-exchange investments, Kris was instrumental in helping to establish the Australian version of the Daily Reckoning e-newsletter in 2005. He is currently the Publisher, Investment Director and Editor in Chief of Australia's most outspoken financial news service — Money Morning.
Kris Sayce

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