It should be a license to print money…
Imagine if you owned a crystal ball that could predict each company’s earnings announcement. With this crystal ball, you know with perfect accuracy which companies would report earnings that beat analyst expectations and which would miss. And you can buy or sell the stocks based on these flawless predictions.
This is the goal of every investor, right? Whether you’re a Warren Buffett-style value investor, a trend follower, or a day trader… at some basic level, you’re trying to figure out which businesses will earn the most money so you can put your money into those shares.
It turns out, your crystal ball would be nearly worthless.
Predicting earnings does not mean you can profitably predict stock prices.
In a paper published last year in the Financial Analysts Journal, two professors computed the gains you could earn with such a crystal ball.
Back in the ’80s, your crystal ball would have earned you 4%-6% more than the market. That’s enough to make you a superstar. Predicting earnings in the old days made sense.
But today, something has changed. In the years since, the advantage has steadily declined to about 2%.
Maybe the market is getting more efficient or various accounting issues have made earnings less reliable. You can debate the reasons.
But the point is this: Even with perfect predictions, you won’t earn much… And of course, no one has a crystal ball. Even if you predict earnings with, say, 80% or even 90% accuracy… that 2% advantage gets wiped out quickly.
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We bring this up because this has been a strange spring. Companies across the board published stellar earnings… and then got beaten down by the market.
For instance, construction-equipment maker Caterpillar (CAT) beat earnings expectations by an eye-popping 33%. But management’s comments that earnings growth may be “as good as it gets” was taken as a bearish warning. Shares plummeted 6%.
Defense contractor Lockheed Martin (LMT) beat earnings estimates by 18%, but shares fell by 6% as well. News outlets said it’s because Lockheed didn’t raise its cash-flow forecasts for the year, but we think those pundits were just grasping for an explanation.
Investors find themselves struggling in this market. After all, earnings should matter. And when so many stocks have what appear to be illogical reactions to their companies’ earnings announcements, it’s strange.
And it exposes some of the underlying characteristics of today’s market that have us growing concerned.
The market is a machine that weighs the consensus of all its participants. When the overriding opinion is optimism and investors expect better things to come, the market will rise. When everyone is scared, the market falls.
But other times, the market has no consensus… or it has shifting viewpoints. That’s when you see odd things happening – like good earnings leading to falling stocks.
Investors are confused. And to us, that means it’s time to be cautious. We want to pare back our risk and stick with “boring” companies.
By boring, we mean businesses that consistently churn out predictable earnings quarter after quarter – companies like Johnson & Johnson, Coca-Cola, and Colgate-Palmolive.
We want businesses that have customers locked into long-term recurring agreements. We want businesses with few competitors and no new upstarts that could come and steal business away.
Many traders don’t like boring stocks because, well, they are boring. Most traders don’t make money on stocks that don’t move. But thanks to our options strategy… we do.
We can pick a stock that doesn’t move and use options to turn it into a steady stream of income payments.
For us, when the market is acting strangely, boring is best.
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Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig and the Health & Wealth Bulletin Research Team
May 23, 2018