I’ve Got Some Good News and Some …
The market these days feels a bit like this old joke:
Doctor: I have good news and bad news.
Patient: Go with the good news first.
Doctor: You have 24 hours to live.
Patient: What?!! How about the bad news?
Doctor: Um…I forgot to tell you yesterday.
The good news for the market is that earnings are coming in better than expected. The bad news is that market prices have already adjusted for this improvement.
According to Thomson Reuters, earnings for the fourth quarter of 2016 are on track to grow 8.4% from last year’s fourth quarter. This is nearly twice the growth rate seen in the third quarter and a good sign for investors looking for stronger growth this year.
What could the bad news be? The bad news is that valuations are higher than ever. Right now the S&P 500 is valued with a price-to-earnings ratio (P/E) of 17.5 times expected earnings. One year ago the S&P 500 traded with a price to earnings ratio of about 15. Even after accounting for the higher growth rate of earnings, the overall market valuation is frothy.
It would be so easy if investors only had to deal with one variable at a time. The challenge of course, is that the stock market is a living, breathing animal, with prices dynamically changing based on fundamental news. If valuations were fixed but earnings growth were accelerating, I’d be pounding the table to buy more stocks.
Unfortunately, it looks to me like valuations have run faster than earnings growth. So, while it’s indeed good news that earnings are growing faster than expected, the bad news, like the doctor says, is that accelerating growth is yesterday’s news. Prices have run up so far, so fast, that most stocks are trading with P/E’s that exceed their growth rates.
Some investors don’t care as much about P/Es. Those that care only about how quickly the rate of earnings growth is increasing are called momentum investors. These investors, or more likely, traders, can make a lot of money in short time. Computer programs help drive these or quantitative traders, or “quants,” into stocks whose earnings growth rates are accelerating. They tend to not care so much about the price of stock but rather focus only on the increasing rates of growth. The bad news for momentum investors is that they can often lose money just as rapidly as they made it. These are high risk trades.
I am what some refer to as a PEG or GARP investor. I look for stocks with growth at a reasonable price (GARP). My favorite metric, PEG, measures a stock’s P/E ratio against its earnings growth rate. If the P/E is less than the growth rate (a PEG less than one), the stock offers good value. A stock with a PEG much higher than one would need to have some very compelling fundamentals for me to like the stock.
Right now it’s hard but not impossible to find stocks to buy that have P/Es less than their growth rates. Of course, like any tenacious analyst, I keep on digging until I find a situation where either the price hasn’t adjusted for growth yet or where I think estimates haven’t yet caught up with improving fundamentals.
In the meantime, I’m not wasting any time selling stocks that have moved up quickly and hit my targets. Just this week in Profit Catalyst Alert I sold one old favorite that is up 41% in less than five months. I’m also buying options on stocks that I think will move quickly, and booked gains of 66% and 140% on two call positions that moved up on good news.