Credit: Investors that follow fundamental valuation techniques like earnings, debt ratios, and cash flow are often frustrated that a company with a great balance sheet can see its stock price continue to fall thanks to market sentiment.
Believe me, the frustration goes further for those of us following macroeconomic trends within countries and regions. Since an asset's value is ultimately a function of its future cash flows, then stocks with strong and trending earnings should increase in price against relatively weaker companies.
Using a regression analysis on the returns to the S&P500 Total Return Index shows a completely different picture.
Through his research for trading strategies, Michael Dever of Brandywine Asset Management, found that 93% of the variance in the index was explained by two drivers. These were: earnings, and how much investors are willing to pay for those earnings. This in itself is not necessarily a shock. What is surprising is the time horizon wherein each of these drivers is dominant.
For periods of less than 10 years, the market sentiment driver accounts for around 75% of the price change in the market, while overall earnings growth is much less significant.
The market sentiment driver, commonly measured through market price multiples like price-to-earnings and price-to-book can have a large and overriding affect on stock prices in any given time period.
This is not to say that earnings analysis is not important. But you need to understand how to use it and how to develop it into a trading strategy with overall market sentiment. The level of earnings and growth is not always as important as the current sentiment in the shares, relative to market multiples and the possibility for a surprise or disappointment in earnings.
The SPDR S&P500 ( SPY , quote ) used to represent the U.S.market for large cap stocks is currently trading around 13.5 times trailing earnings, well below the long run average of 16 times earnings. This reflects the amount of fear and bearish sentiment among investors. Despite generally strong earnings through the last few quarters, stocks have had a hard time outperforming other assets.
Emerging Markets are not immune to the phenomenon. The iShares FTSE China 25 Index ( FXI , quote ) trades at just 9.0 times trailing earnings of the companies in the index, while those in the Market Vectors Russia ETF ( RSX , quote ) sell for just above 6.0 times earnings.
Investors can use market sentiment and relative valuation to devise a trading strategy around earnings and macroeconomic reports. My own strategy revolves around a set of rules that depend on three criteria: the sentiment within the overall market, the sentiment within an individual stock or asset class, and the possibility for an event to surprise or disappoint.
If overall market sentiment is bullish, even a disappointment in an economic or earnings event may only have a neutral effect on the stock. Conversely, if overall market sentiment is bearish, then an upside surprise may not drive individual stock returns, which may lead to a neutral or overall short strategy.
There are gradations within the level of market sentiment, and my own strategy involves a fairly complex scoring system, but investors can start with the basic idea and build from there.
Despite headlines in the financial press, market sentiment does not normally turn on one event and usually takes at least a couple of weeks to change.
Use historical data, available through most internet investing accounts, to backtest different strategies according to P/E measures within the market, individual stocks, and given announcement outcomes. Once you have developed a strategy, you may want to incorporate options for leverage or hedging purposes.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
