By: Tim Bennett
13.11.2018
2018 has provided a classic demonstration of why investors should never pay too much attention to forecasts, says Tim Bennett in his latest video.
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Why short-term stock market predictions rarely make sense
2018 has provided a warning to anyone who pays too much attention to forecasts. Despite a strong earnings picture, total returns have been flat for the year as a whole, a fact that has wrong-footed many investors and analysts. Here’s why.
Background
Despite the fact that forecasting a sometimes volatile and fickle stock market is something of a mug’s game, plenty of analysts and other “experts” try to do just that. The problem, however, is well put by Josh Brown;
The problem
As I explain in another video, “The Three Key Drivers of Stock Market Returns”, total returns from shares can be broken down into three components, all of which need to be understood by investors;
It is the third of these that causes the most headaches. Built into stock prices is the price/earnings multiple determined by the market. Unlike dividends and earnings (EPS), this is subject to rapid short-term adjustment as it reflects how market participants feel about the future.
The S&P 500 in 2018
The following chart breaks down the performance of the S&P 500 in terms of these three key ingredients. The picture it reveals is interesting, to say the least;
In essence, having risen together for three years between 2015-17, the P/E multiple has headed sharply south in 2018 whilst dividends and earnings have remained fairly buoyant. The effect has been to reduce total returns to around zero as “multiple contraction” has wiped out positive earnings and dividends.
Why does this happen?
Such a sudden change in this vital third ingredient of total returns can be explained by three somewhat intangible factors;
Despite some decent earnings numbers, share prices have declined in the latter part of this year as sentiment has soured, liquidity has worsened in some parts of the market and the macro backdrop has taken its toll (thanks to rising interest rates, trade disputes, Brexit and Saudi Arabian politics).
So is it all gloom and doom for equity investors? No.
So is it all gloom and doom for equity investors? No.
The opportunity
Short-term pullbacks can create a good entry point for long-term investors who are prepared to weather them and not panic-sell, or start to churn their portfolios needlessly. That’s because when you get a mismatch between expectations and earnings, you sometimes also get valuation anomalies as the market overdoes its pessimism. That’s why monitoring all three components of equity returns is so important, as is maintaining sufficient liquidity to be able to take advantage of any opportunities to deploy capital as they arise.
