The year 2017 is shaping up to be one of the best years in a generation for international stock market investing.
For the first time in any year, the Morgan Stanley Capital International All Country World Index has posted a gain every single month through October. The media will offer all kinds of explanations, most of which are speculative and unsupported. Pick your cause: low oil prices, low interest rates, improved gross domestic products, Trump, Obama. In the end, no one really has any clue about what drives the investment markets.
But I do. And I will share it with you right now as long as you promise not to give away the secret!
Basically, there are two factors that determine stock prices. The first is company performance, most commonly measured by net profit (earnings). For a company whose earnings are growing from year to year, you would expect its stock price to concomitantly increase.
The difficulty arises when we try to estimate the amount of the increase. Should an annual 10 percent growth in earnings translate to an annual 10 percent growth in stock price? Regrettably, it rarely works that way.
And the primary reason is the second factor – investor sentiment. It can be measured using a company’s price/earnings (P/E) ratio. This is a multiplier that indicates how many dollars (or euros or yen) an investor is willing to pay for one share of the company’s stock. When a P/E ratio is high, it means investors are comfortable paying a lot of money to own that stock. When it is low, investors consider the stock a riskier investment in terms of future expected returns, and as a result are unwilling to pay as much.
You may have heard in the media or even from some investment professionals that – based on various P/E ratio measures – the U.S. stock market is overvalued right now. I don’t agree.
Every day millions of investors get together with the help of brokers and market makers to agree on a price for buying and selling the shares of every publicly traded company. So those prices must be valued correctly by definition. It would be more accurate to say that stock prices today are highly valued as compared to historical valuations. Or, put another way, investors are willing to pay more for a share of stock today for a company generating a certain level of earnings than they were willing to pay in the past.
What does that tell us about future stock prices?
Take Apple Inc., for example. If the company’s earnings were to increase by 20 percent in 2018 and investor sentiment did not change from today’s P/E ratio of approximately 18, then Apple stock would in fact be priced 20 percent higher next year.
Unfortunately, investor sentiment is driven by human emotions and behavior, which no one except Isaac Asimov has ever been able to predict.
If Apple’s P/E ratio were to fall to 9 next year, then even with a 20 percent increase in earnings, its stock price would drop by 40 percent (to its current price x 120 percent x 50 percent, or to 60 percent of its current price). Although we can calculate this after the fact, we have no way of knowing in advance how comfortable or averse investors will be toward the risk of owning Apple or any other stock next year.
Therefore, even if you could predict future company performance, adding investor sentiment to the mix makes predicting future stock pricing virtually impossible. So is there really any value in knowing what’s driving market performance today?
Los Altos resident Artie Green is a Certified Financial Planner and principal at Cognizant Wealth Advisors. For more information, call 209-4062, email artie.green@ cognizantwealth.com or visit cognizantwealth.com.