Earnings Still Matter!

One of the most important new trends is that stocks are becoming more volatile during earnings season. As you can see from the chart below, earnings moves are 4 times the size as the average daily move. The most obvious explanation that many give for this is the prevalence of ETF investing. ETF investors don’t care about valuations and fundamentals. They aren’t studying how big a firm’s moat is. That’s a big advantage for stock pickers as you get these great firms at a discount assuming you can spot them. ETF investors dominate trading when earnings aren’t being reported. Then when earnings are reported, the traders who focus on the short term move the stocks. This can be problematic for ETF investors. It shows that fundamental investing isn’t dead.

This is great news because Japan is having problems with moral hazards. The central bank is buying stock ETFs. It is a passive investor which doesn’t reward great reports which means incentives for good execution are eliminated. This hurts innovation and productivity. While the Federal Reserve isn’t buying stocks and the Swiss Central bank doesn’t own enough stock to manipulate the whole market, ETF investors are still passive investors which could have a similar effect to central banks. The JCB buys ETFs just like investors in America. The difference seems to be that the JCB is shrinking the float of stock which can be traded as investors don’t think the JCB will ever sell. If you only think the JCB will buy stocks, you would simply ride the wave. There’s no point in trading it.

In America, the ETF investing is a new phenomenon. Many investors, like myself, don’t think the trend will last forever. I think the ETF investing will reverse in the next correction when they are exposed to the full brunt of the crash. If you think the market isn’t rigged to go higher, then trading individual names makes sense. It’s a self-fulfilling prophecy at this point because the market’s action is proving that fundamental investing still works since stocks are volatile around earnings season. This encourages traders to participate, making for more volatility.

I would like to add to the obvious and probably correct take that ETF investing is compressing volatility which explodes during earnings season. The first point is that the stock market has been very quiet in the past few months which makes normal volatility during earnings season look larger in comparison to regular trading. Say realized volatility was normally 13 and earnings season volatility was 18. If realized volatility fell to 7, then a regular earnings season with 18 realized volatility would be way higher and cause the line in the chart above to move up. The fact that the market has had a lower realized volatility is partially due to ETF buying and partially due to the great corporate earnings which makes this a related point.

The second point is that earnings have become more important to stock market returns in the past few quarters. It doesn’t look like it because the transition has been made smoothly, but stocks are now less reliant on central banks as the Fed has moved rates higher. We’ll see the moment of truth when the unwind starts in late 2017; it might be priced in because it’s in the central banks’ guidance. However, there might be some holdouts who don’t believe the ECB and the Fed, making for choppy trading when it starts. There also has been a transition to relying on earnings more in the past 6 months because, at the beginning of the year, more investors believed tax reform will pass than do now. The great first half earnings, means stocks don’t need tax reform to grow profits.

The chart above is an interesting point which is worth considering when determining whether the market is frothy. Stocks are in a trend where the earnings misses are causing more weakness. That is the opposite of froth. This isn’t a signal that stocks are a great long term buy as valuations are the only way to measure that. However, it does indicate that the top in the market may not be near. It also indicates that a bad earning season will end the bull market; it will cause more pain than the 2015-2016 earnings recession as the Fed is less accommodative now. Bad earnings are probably causing stocks to fall more now because the overall trend is ETF buying pushing stocks higher. Corrections to the mean occur along with depreciated expectations in firms that miss estimates to form a nasty fall.

In a previous article, I mentioned that the top tech stocks rely on their great earnings to power higher. The specific stat is that over 50% of FAAMG’s performance occurs during earnings season. Netflix had a huge boost after its report while Microsoft was a dud this week, falling about 1% on Friday after beating results on Thursday afternoon. This means that Alphabet, Amazon, Apple, and Facebook’s earnings in the next few days could be big catalysts to push the market higher after it took a minor breather on Friday, closing slightly in the red. Even with that selloff, the VIX reached its lowest level since 1993, closing at 9.31. If the market is up on Monday, the VIX could hit a record low.

Conclusion

Stocks are clearly expensive if you look at the Shiller PE. It has only been higher during the 1920s bubble and the 1990s bubble, which may make you think earnings don’t matter. However, earnings still matter according to the recent Goldman Sachs study which shows that earnings results matter more to performance than any time in the last 18 years. Buying great companies and profiting might be simpler than you think because you’re competing with investors who don’t care about what they’re buying. When the VIX reaches a record low next week, bears will be making the case that complacency has reached a peak, but looking at the performance of stocks which miss estimates you can see that froth isn’t as prevalent as you’d expect. The 10-day VIX is a ridiculously low 4.78. That’s probably unsustainable, but it doesn’t mean the bull market will end.

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