Many factors contribute to stock prices. Among the most important factors is earnings growth, something many of you already know. But another is sentiment.
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I have long believed sentiment is the most important factor.
Sentiment explains the internet bubble in 1999. Investors believed the internet was going to revolutionize commerce... and that belief turned out to be correct. But it took time for companies and consumers to learn how to benefit from the internet. Market prices of stocks simply got ahead of earnings.In a bubble, the gap between sentiment and earnings widens until it eventually becomes too large and the prices of stocks fall.
We also saw the impact sentiment can have during the 2008 financial crisis. In 2008 and 2009, sentiment fell sharply -- and so did stock prices. Below, you can see the Michigan Consumer Sentiment survey, which a popular gauge of how consumers feel. Notice the irrational exuberance in early 2000 and the plunge in 2008.
Right now, sentiment is high. According to the Nobel Prize-winning economist Robert Shiller, high sentiment explains why the stock market is richly valued right now.
Shiller recently noted that the recent market could be considered as rational. He found that, when adjusted for inflation, stocks have gained 24% since January 2017, the beginning of the Trump administration. Over that same time, earnings (again, adjusted for inflation) increased by 20%.
He recently wrote:
"With prices and earnings moving together on a nearly one-for-one basis, one might conclude that the U.S. stock market is behaving sensibly, simply reflecting the U.S. economy's growing strength."
But it is important to bear in mind that earnings are highly volatile. Sudden sharp increases tend to be reversed within a few years. This has happened dramatically more than a dozen times in the U.S. stock market's history.
Based on my research, a swing in earnings is set to happen again soon. In the table below, I summarize earnings growth estimates for the next year.
You can see a sharp slowdown is expected. Earnings for 2018 were boosted by tax reform, but that was a one-time factor. Now, earnings cannot continue growing that fast, and that means stock prices are likely to adjust.
Shiller concluded that "a bear market could come without warning or apparent reason, or with the next recession, which would negatively affect corporate earnings. That outcome is hardly assured, but it would fit with a historical pattern of overreaction to earnings changes."
While a bear market can come without warning, earnings forecasts are providing an early warning to prudent investors. The slowdown in earnings is underway, and when this is widely recognized, I expect the next bear market to take hold.
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You Can Still Profit, Even In A Bear Market
But leading up to the bear market and even in a bear market, there will be trading opportunities. One of the strategies I use to find opportunities is to search for stocks of companies that will report earnings soon. It's often possible to make an income trade before that report to benefit from volatility in the stock.
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