Ask anyone what ultimately drives the market and they will give you all sorts of answers, nearly all of them wrong.
If you were to ask someone that question today, they may offer the tariff issues, interest rates, the government shutdown, the President or Democrats, technical indicators or consumer sentiment. Wrong, wrong, wrong, wrong, wrong and again wrong. There are some answers you may get no matter when you ask the question, such as the unemployment rate, federal debt, and on an on. Again, not correct.
The stock market cares about only one thing: anticipated earnings. If companies are expected to make more money, their share prices rise. The stock price is simply a reflection of a company’s earning power. Everything else is noise.
Assume for a moment that you are going to buy a sandwich shop. What do you care about?1 The only factor you care about is anticipated earnings. If you buy the sandwich shop, you are doing so because you believe the profits earned in the future will justify the purchase price.
To arrive at this conclusion, though, you will look at other factors that will affect your ability to make money owning this sandwich shop. For example, if interest rates are low, you will be able to make lower payments on your loan, thus making the shop more profitable. In this case, interest rates matter only because they affect your anticipated earnings. Commodity prices will also likely matter, as oil and food are commodities. If oil prices go up, it will cost more to have the food delivered to your shop every day. Rising food costs increase your expenses as well. Both increases in commodity prices eat away at your bottom line, thus hurting anticipated earnings. Consumer confidence matters because if consumers think their financial world is collapsing, they will forgo your $8 Mega Sandwich Deal2 and make the kids grilled cheese sandwiches at home. That will drive down sales, which would impact your earnings. You get the idea.
Note, however, the important word here is “anticipated.” No one cares about yesterday’s earnings. For example, let’s go back to that sandwich shop you want to buy.3 You are talking to the owner, reviewing her financials, and you can see she made $100,000 each of the last 3 years selling about 20,000 sandwiches a year. This sounds pretty stable, so you are thinking about offering her $200,000 for her business, knowing that you can make $100,000 per year once you pay off the debt it takes to buy it. But, you are too smart for that. You notice that she sells 5,000 sandwiches each year to a large corporate client. That client just went out of business. If you back those sales out, the sandwich shop would be much less profitable, so you would no longer offer the same price. You are focused on the only thing that really matters: anticipated earnings.
The bottom line is this: All of the other factors in the economy matter only because people buying and selling stocks are trying to determine how the changes in various “indicators” – like unemployment, interest rates, tariffs and so on – will ultimately affect a company’s anticipated earnings.
No one cares how much Facebook, Google and Apple made in the past. They want to know how the regulations around consumer privacy and sharing of data will impact the future earnings of these companies. No one cares if Netflix made a million or one hundred billion last year. They want to know if their earnings will be hurt now that Disney is getting ready to enter the streaming video business. No one cares how much money Tesla made selling electric cars in the past. They want to know if Tesla will be able to prevail as a profitable enterprise once BMW, Mercedes, GM, Ford and every other major car manufacturer gets into the electric car business in a big way. It’s like the stock market is a 1980’s song from Janet Jackson, constantly screaming “What have you done for me lately”?4
When I try to play any sport with my kids I feel like an inanimate object, so it makes perfect sense that I will dive into my usual attempt at a sports analogy. Let’s say the New England Patriots are about to play the Kansas City Chiefs and the odds are “even”, meaning both teams are expected to have an equal chance to win. Bettors line up on both sides, with half putting money on the Patriots, and half putting money on the Chiefs. But, three days prior to game day, a rumor leaks on line that Tom Brady, the quarterback for the Patriots, may have suffered an injury and may not play. Bettors will immediately start favoring the Chiefs, and they will now be favored to win, even though there is no certainty Tom won’t play. Let’s say two days prior, the Patriots announce that in fact, Tom Brady is injured and will likely not be playing. Given there is more certainty, bettors will now very heavily favor the Chiefs.5 Now, let’s say that one day before the game, the Patriots announce Tom Brady recovered faster than expected, feels 100% healthy, and is definitely going to play. The bettors will no longer favor the Chiefs, or certainly won’t favor them as much. The point of this (exhaustive, I know) analogy is that the betting market is moving in anticipation of what will happen, even though the game hasn’t even started yet.
The stock market behaves the same way. The market rises in anticipation that future earnings will be good enough to justify the price paid today. It also declines if it anticipates that future earnings will be lower. If you are running a lemonade stand, you expect to sell more lemonade if the weather forecast shows 100 degree weather over the next few days. You would stock up on supplies. If the forecast is for cold showers, you will behave differently, expecting to sell far less.
So, that brings us back to today. The stock market has completely fallen apart over the last few months, officially entering bear market territory, which is simply defined as a decline of 20% from the high. Why? With unemployment at historically low levels and corporate profits at high levels, how can this make sense? Because the market sees a lot of factors that may negatively impact future earnings. These factors include all of the things everyone is talking about, including interest rates, tariffs and political turmoil. In short, the market is concerned the combination of all of these things, to varying degrees, may cause companies to do less well in the future. Or as economists like to call it: a recession.
Of course, so many variables go into guessing anticipated earnings that the market is not always right in the very short run (even though it is always right in the long run). For example, you can buy the perfect sandwich store in perfect conditions and then have a multitude of surprises derail your profits, like a crime in the area, unforeseen road construction blocking access to your shop, and so on. Likewise, we can have a near perfect economic environment, and someone can fly a plane into a building and turn everything upside down overnight. We can have a market in turmoil and get resolutions that are much tidier than expected too, which would likely drive the market higher quickly. And that’s exactly how recoveries tend to happen: quickly.
Now, for the good news. Bear markets are very poor predictors of recessions. While bear markets occur about every five years, some of them are very short lived. In fact, on 9 separate occasions, the market has been wrong, moving into bear market territory without a recession following.
Also, unlike your sandwich store, which can go to zero, the stock market itself is resilient. Every time in history, no matter how bad things have appeared, U.S. companies as a whole have ultimately found a way to not only make money, but to make more money than they did before. The market has always not just recovered, but gone on to new highs. Every. Single. Time.
Footnotes
- Besides, apparently, salami.
- I certainly hope you are going to invest the time to come up with a better sandwich deal name than this!
- Why am I so hungry?
- I’m sorry.
- Yes, I am still running with this.
