What to do when earnings slow
Joel Dresang: Marc, we talk all the time about the importance of corporate earnings and interest rates for long-time investors. Let’s talk about corporate earnings, which are at all-time highs, but we’re hearing more reports that they’re slowing down. How should investors take that?
Marc Amateis: Don’t assume that just because earnings are slowing down that that means that the stock market is in trouble.
In fact, there is some very interesting data going back 90 years that shows that year-over-year on a quarterly basis, the stock market actually does best when earnings are between 20% lower than the prior year and 5% higher – actually better than if earnings are a lot higher than the prior year.
Joel: Why would that be?
Marc: The first reason would be that the market’s a leading indicator. Investors are always looking forward. And when earnings are rushing ahead at a torrid pace, investors know that that’s just not sustainable. And so, eventually, they start dialing it back a little bit.
The second reason, and maybe that pertains more to kind of the time we’re in now, is investors also know that if earnings are roaring ahead, that makes it a lot more likely that the Fed is going to feel that is has to start tightening interest rates, start to tighten up on monetary policy, prevent inflation from taking hold, prevent the economy from getting too hot.
Joel: So, corporate earnings are still earnings, and they’re growing but not as hot and not too cold. It’s sort of a just-right Goldilocks level?
Marc: Right. And investors and the market seem to like that kind of a setup where you have earnings growth or maybe you have earnings that are even not growing, but they’re still pretty decent. And it tells them that inflation’s not going to get out of control, that the Fed isn’t going to start tightening the screws and that the markets have a while yet that they can run.
Joel: So what should investors do, knowing that we’re in that kind of a period right now?
Marc: Don’t get pessimistic just because earnings are slowing down. But also, don’t get overly optimistic either. Remember, that’s just one data point. There are all kinds of data points that you can look at, and sometimes – a lot of times – they conflict.
So, I think you stick to the plan, you watch multiple data points. Watch price-to-earnings, price-to-book, price-to-sales ratios. And start to get worried when a lot of data points start getting pricey.
Joel: And when you say get worried, it’s not that you’re going to run for the exits and take all of your money out of stocks.
Marc: Right. But that’s the time to be prudent. Rebalance your portfolio. Dial it back a little bit. Take some of those gains that you made over the years knowing that you can’t foresee, you can’t predict with any real certainty where the market is going shorter term.
Marc Amateis is vice president and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
Money Talk Video by Peter May
(initially posted May 21, 2015)
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