Published February 07, 2012
Why are stocks going higher when there is so much risk to earnings
Simply put, stock prices move up and down based on expected earnings. However, institutional investors and professional money managers add one more criteria to the evaluation process. With more than 90% of the volume on the stock market coming from the fingertips of these professionals, I believe it is important for individuals to understand how these people think about current market valuations.
To get technical, with the 10-year Treasury trading at historic lows, the stock market looks two times more favorable today than bonds do with respect to valuation. This valuation model takes into account three major statistics:
• Earnings forecasts on stocks
• P/E multiples
• Interest rates
The Bull case for the stock market is that interest rates will remain low, earnings continue to grow and P/E multiples expand. When the 10-year Treasury is very low, the stock market warrants a much higher P/E multiple.
The Bear case for stocks is a reduction in earnings, an increase in interest rates, and a contracting P/E multiple. As I wrote recently in “Here's Why the Market Scares You”, there are 4 factors that I fear for the stock market. All target earnings and expected earnings. To summarize, they are:
• Europe represents 20% of the world's gross domestic product and their economy is in a crisis
• Interest rates on the long end of the yield curve in the United States continue to rise.
• Commodity prices are on the rise
• Iran is a wildcard
Based on where interest rates are, professionals simply look at valuations, and stocks appear much more favorable than bonds. However, in a blink of an eye, these valuation models can change. We can see earnings come under pressure for these companies because of rising commodity prices, pressures from Europe, the world economy slowing down, constant fear of Iran and rising energy prices domestically.
Be happy stock prices are moving higher if you are invested, but watch out for the “sucker punch.” If earnings come under pressure and interest rates start to rise, this market could swing around very quickly.
Ed Butowsky is an internationally recognized wealth manager. His upcoming book titled "Are You Committing Financial Suicide?" is expected to be released this spring.