Investors Sell off Stocks of Companies with Good Results

Investors are learning that stock prices don’t always follow earnings.

Over the long term, corporate earnings tend to grow at about the same rate as gross domestic product (GDP), and stock prices tend to rise at the same rate as earnings. However, the key words here are “long term.” There can be a lot of divergence in these factors over any short-term period.

Since 2013, stock prices were closely tied to earnings. In fact, about 80% of the stock gains since then occurred during earnings season, according to a study by Bespoke Investment. That trend hasn’t continued, though.

When earnings from the fourth quarter of 2017 were reported in early 2018, earnings growth was robust, but stock prices declined. That has been happening again now as earnings reports from the first quarter of 2018 have been rolling in over the last few weeks.

It still is early in earnings season, but most of the companies reporting so far have delivered good results. More than 76% of companies exceeded their earnings estimates after the first 10 days or so of earnings season. It is rare for more than 70% of companies to exceed their earnings estimates. If this trend holds, this could be the strongest quarter since 1999.

Yet, stock prices have been weak. The trend has been for a company’s stock price to increase as strong earnings are announced, but then sag for the rest of the day. By the close, the stock price is either barely positive or negative.

Four factors determine changes in stock prices: earnings, valuations, the discount factor (interest rates) and the risk premium.

Since the end of the financial crisis, stock prices have increased far more than earnings. That means valuations have increased, and you’ve probably heard that valuations are near historic highs. In other words, investors have been willing to pay more for each dollar of earnings.

There are a couple of reasons investors have bid up valuations.

Low interest rates are one reason. When rates are low, stocks are more attractive than many alternative investments and it’s reasonable to place a higher value on each dollar of earnings. Since 2015, though, the Fed has been tightening monetary policy, raising short-term rates and letting market rates rise. This week, the yield on the 10-year Treasury bond closed above 3% for the first time in four years. This makes other investments more attractive than they were and stocks less attractive.

Secondly, the risk premium is the higher return investors demand for investing in something other than risk-free treasury securities. When interest rates are low and the economy is doing well, investors accept a lower risk premium and will take more risk, but when rates rise and valuations are high, stocks appear to be more risky and investors demand a higher risk premium. In other words, they will buy stocks only at lower prices.

Factors outside the markets and economy also can cause investors to demand a higher risk premium. Lately, we’ve had headlines about trade wars and geopolitical tensions, among other things. These events undoubtedly are influencing stock prices.

So, it’s no surprise that stocks aren’t rising with positive earnings reports. Stocks soared ahead of earnings the last few years because of low interest rates and a lower risk premium. Rates and the risk premiums are rising, and investors fear the economy and earnings might not be as strong in a year or so. Add in the factors outside the economy and markets, and it’s easy to see why investors are becoming cautious. We’ve been expecting these developments, and they are why we’ve been reducing U.S. stock positions.

The Data

Existing home sales increased 1.1% for the month and now are down only 1.2% over 12 months. In addition, the median home price increased 3.9% for the month, bringing the 12-month increase to 5.8%.

The new home sales report was very strong. Sales increased 4% for the month to 694,000 annualized, and last month’s number was increased substantially to 667,000 from 618,000. In addition, the median price increased 3.5% for the month.

Home prices still are increasing steadily despite rising mortgage rates. They rose 0.8% for the month and 6.8% over 12 months, according to the S&P CoreLogic Case-Shiller Home Price Index. Similarly, the FHFA House Price Index showed a 0.6% monthly increase in prices and a 7.2% jump for the past 12 months.

The Philadelphia Fed Business Outlook Survey increased to 23.2 from 22.3. That’s not in line with the other Fed regional bank surveys, which declined from last month, but details of the survey did show slower growth. New orders and backlog orders, for example, declined significantly.

The Richmond Fed Manufacturing Index was more in line with the other regional surveys, registering a decline to negative 3.0. That’s the first negative reading since September 2016. Shipments and new orders were among the factors declining significantly.

Durable Goods Orders presented mixed news. The headline number was a healthy 2.6% increase for the month and 9.5% over 12 months, but a lot of that increase was from aircraft orders. Exclude transportation, and orders were unchanged for the month and up 6.7% over 12 months. More importantly, core capital goods were down 0.1% for the month and up 7.0% for the past 12 months. Core capital goods is basic business investment, so it is disappointing to see it decline after months of solid growth.

Consumer Confidence, as measured by The Conference Board, rose to 128.7 from 127.0. People are very optimistic about jobs and income, but only 32.7% anticipate higher stock prices over the next year.

All sectors of the economy continue to grow, according to the PMI Composite Flash mid-month index. The composite rose to 54.8 from 54.3. Manufacturing increased to 56.5 from 55.7, and services increased to 54.4 from 54.1.

The Index of Leading Economic Indicators from The Conference Board increased 0.3%. That number is down from very strong readings in the previous three months, but in line with expectations. It indicates continued growth, though perhaps at a lower rate. Key reasons for the lower reading are higher unemployment claims and a reduction in average factory weekly hours.

New unemployment claims declined 1,000 last week and another 24,000 this week. They’re now at the lowest level since 1969. The four-week average is 229,250.

The Markets

The S&P 500 declined 2.50% for the week ended with Wednesday’s close. The Dow Jones Industrial Average lost 2.65%. The Russell 2000 fell 2.08%. The All-Country World Index tumbled 2.26%. Emerging market equities lost 3.82%.

Long-term treasuries declined 2.61% for the week. Investment-grade bonds fell 1.43%. Treasury Inflation-Protected Securities (TIPS) lost 0.96%. High-yield bonds slid 1.01%.

On the currency front, the dollar gained 1.83%.

Energy-based commodities fell 0.80% for the week. Broader-based commodities lost 1.50%. Gold declined 1.93%.

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