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Tags: earnings | recession | invest | econonmy

Will Earnings Season Unlock Another Correction?

Will Earnings Season Unlock Another Correction?

(Dollar Photo Club)

By    |   Friday, 21 October 2016 11:18 AM

In the past two years, we’ve had three periods now where stocks have pulled back 10 percent from their highs. Those are healthy corrections, but we haven’t gotten a full bear market. That requires at least a 20 percent decline from the top.

Many investors are sitting on the sidelines waiting for that drop. If they’ve been waiting long, say, since the financial crisis, they’ve missed out on one of the longest and most powerful stock market rallies of all time.

I can’t blame them. After all, to get that rally we’ve had to deal with eight years of near-zero interest rates, funneling money into stocks that might have otherwise gone into less risky ventures like bonds. Those sidelined investors might also point to high valuations in the market as a whole. They’d be right. The S&P 500 Index currently trades at 24.68 times earnings. Historically, 15-17 is the average range, and even 20 is pushing it.

We’ve only had a higher P/E ratio for the S&P 500 as a whole on two occasions. In 2000 during the tech bubble, the stodgier stocks of the S&P 500 only traded at 40 times earnings — still a big enough multiple to get cut more than in half in the ensuing burst bubble. And during late 2009, when corporations were slashing expectations amid the Great Recession, the S&P’s multiple shot up to over 60. It got back under 15 only in late 2010, thanks to a massive bear market and subsequent corporate recovery.

So, yes, stocks are high-priced. And they’re trending higher on an earnings basis. If history is any guide, we have more room to run before valuations get so extreme that the bubble will burst.

But that’s just looking at the market as a whole. Even without another broad-based market correction, there’s always a bear market somewhere. Plenty of individual names have fallen more than 20 percent this year, and not all of them have deserved to fall so much.

For example, earlier this year, hard drive manufacturer Seagate Limited (STX) saw shares fall to multi-year lows from a peak of $70 to briefly under $20. Why? In the first quarter, the company reported a modest 4 percent drop in sales. That was enough to create the perception that the hard drive business was going out of style. And as one of two major players in the hard drive space, Seagate would soon be facing an existential crisis.

But Seagate got better. In the second quarter, it reported a modest increase in sales above expectations. Shares shot up nearly double from their panic-lows just a few months earlier. Mr. Market’s overly pessimistic view changed sharply to a surprisingly optimistic one in a very short amount of time.

Companies good and bad will get dinged by Mr. Market at times. That’s true of bull and bear markets. And usually, we see that happen the most during earnings season. After all, companies don’t just report how the previous quarter ended up. They also make forward-looking statements and adjust analyst expectations in light of the ongoing business. It’s this forward guidance that can send shares of a stock diving despite great earnings the prior quarter. Or vice versa.

That’s not some kind of trend susceptible to change. It’s a fact of how our markets are structured. That means we’ll see new opportunities in the coming months to buy companies that have fallen out of favor. What do I mean with out of favor? A few factors come to mind.

First, as with our Seagate example, we want to see Mr. Market have a disproportionate reaction to some small item of bad news. We want to see shares drop far in excess due to a one-time earnings drop, sales decline, or overly cautious forward statements from management. Markets don’t just react, they overreact. And investing in the biggest overreactions can be wildly profitable.

Second, we’re going to need a strong dose of patience. Since we’re investing in the impatience of others — those who want out of the stock at any price — it’ll take time to recover. Companies generally report bad quarters from time to time, but if you’re investing in beaten-down individual names, the turnaround can take at least a year.

Third, with this strategy you need to narrow down the entire investment universe to the best names. While plenty of companies get needlessly beaten down, they should still be profitable — and capable of paying a dividend. Since we know that investing in out-of-favor stocks takes time to play out, the last piece of guidance is simple.

In other words, get paid to wait. If you buy at the right price and things go well, you can add dividends on top of your capital gains. And if a company does well over time and can raise the dividend, you’ll start to compound your wealth that much faster.

When Seagate got down into the $20 range, its dividend reached double digits. The yield’s a lot lower now that the share price has nearly doubled. Buy when yields are high and expectations are low, and you’ll do fine over time.

Those are some of the factors I’ll be keeping an eye on as earnings season unfolds. With plenty of companies out there trading below the market average, a short-term hit could create a series of individual bear markets in stocks — declines big enough to justify buying now.

As for the overall market, it’ll still be a bumpy ride in the coming few weeks, given the added dimension of the election. But if you view it as a crisis, you’ll be like those folks waiting for the next big bear market in stocks. It might be a long wait.

If you view the next few weeks as an opportunity, you’ll find individual names getting beaten down to the point where they’re more than a fair price. Just stay patient and get paid to wait, and you’ll do fine.



Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report.

© 2022 Newsmax Finance. All rights reserved.

If you view the next few weeks as an opportunity, you’ll find individual names getting beaten down to the point where they’re more than a fair price. Just stay patient and get paid to wait, and you’ll do fine.
earnings, recession, invest, econonmy
Friday, 21 October 2016 11:18 AM
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