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Timing the Market: EPS is a Lagging Indicator

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Timing is Everything

In both life and markets, timing is a critical ingredient to success and often impacts the outcome of a situation. For example, you can meet the right partner at the wrong time in your life or interview for the right job at the wrong time in your career. Or imagine you invested in shares of Amazon (AMZN - Free Report) at or near the peak of the dot com bubble in 2000. While ultimately, the company would become the dominant player in the eCommerce space and a massive winning stock, you would have likely been stopped out or suffered fatigue from holding shares.

The General Market Direction has the Greatest Impact on Stocks

Because most stocks tend to follow the direction of the major indices, one crucial factor that can significantly increase our chances of investing profitability is to be in sync with the direction of the major market indices. In other words, “so goes the S&P 500 Index, so goes your portfolio”. Below is a chart of Apple (AAPL - Free Report) versus the S&P 500.

Zacks Investment Research
Image Source: Zacks Investment Research

Price Bottoms Precede Earnings Bottoms

But like individual stocks, the general market also requires timing. In the long run, markets are driven by earnings growth. However, historical precedent tells us that in bear markets, stocks tend to bottom long before earnings. In other words, a stock’s price tends to trough long before earnings turnaround.

Zacks Investment Research
Image Source: Zacks Investment Research

The chart above represents the S&P 500’s performance (blue line) above the S&P’s EPS. In the past two bear markets (COVID-19 correction of 20’ & the Housing Crisis of 08’), the S&P 500 bottomed roughly three quarters before earnings turned around and began to accelerate again! In the aftermath of the dot com bubble, price and EPS bottomed simultaneously. Said another way, at some point in the last legs of a bear market, the investors begin to discount the future and tend to look past weakening earnings data.

How to Time the Market

So, if we can’t rely on real-time earnings data to lead us, what should we depend on?

·      Zack’s Consensus Estimates: While most of us do not have a crystal ball into earnings, Zack’s processes information from roughly 3,000 analysts at over 150 different brokerage firms to provide consensus analysts estimates moving forward.

Zacks Investment Research
Image Source: Zacks Investment Research

·      Guidance: Though paying attention to the current quarter is important, most companies also provide investors with forward-looking statements and EPS guidance.

·      Participation: Wide participation is a signal of a strong market. A new uptrend is more likely to work if several sectors are acting strong and leadership is broad. Market breadth (number of stocks up vs. down), new highs vs. lows, and number of stocks above their 50-day moving average are some tools traders can use to measure participation.

·      Reaction to Earnings:Most investors would be hard-pressed to predict the price action of a stock following earnings if they were given the earnings ahead of time. More times than not, the reaction to a report and earnings season is more important than the report itself.

Summary

Ultimately, earnings dictate the direction of the market. However, stock market history suggests real-time EPS is a lagging indicator. Instead, investors should pay attention to consensus estimates, guidance, market participation, and earnings reactions.


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