Weekly Update

The Fuel for Stocks

Tagged: , , , , , ,

Published October 22, 2021

The stock market is driven by earnings + liquidity + sentiment. With the Federal Reserve providing money at near-zero interest rates, the liquidity piece of the formula has been overflowing. Sentiment, or how optimistic/pessimistic investors are regarding the economy and markets, has generally been favorable. Corporate earnings have been stellar, rebounding strongly from the Covid-induced weakness. The chart below shows how corporate earnings are now well above pre-Covid levels and projected to grow about +6.5% per year.

S&P 500

If liquidity and sentiment remain the same, we would expect the stock market to grow at a similar rate as earnings, +6.5% per year.

But liquidity and sentiment are ever-changing. The S&P 500 at 4550 on projected earnings of $220 per share gives us a price to earnings ratio of more than 20 (20.7). The number 20.7 represents the combination of liquidity + sentiment (L+S). If that 20.7 number holds, the projected 2022 earnings of $235 should lead to an S&P 500 value of 4865, a gain of almost +7% from current levels. But we know the Federal Reserve will begin pulling back liquidity over the coming year. Maybe that lowers our L+S number to 19. If so, then we project the S&P to trade at 19 x 235 = 4465, a decline of almost 2% from the current level. If stocks were to decline -2% over the coming year, maybe that leads sentiment to slip and, just like that, stocks can trade flat even while corporate earnings are growing well.

That’s a negative scenario embraced by the bears. It is hardly far-fetched. It seems pretty certain the Federal Reserve will pull back on liquidity over the coming year. Can sentiment rise further to offset the reduced liquidity and maintain a price/earnings ratio above 20? Even if the ratio pulls back fractionally, the stock market would show little change over the coming year. The point being that a small change in liquidity + sentiment can drive a big change in the stock market – magnifying the trend in corporate earnings when investors are optimistic or pessimistic. The surge in liquidity and optimism of a post-Covid economic recovery may or may not already be fully in place. That is why many market observers expect stocks to become more volatile.

None of these elements affect our market models directly. Nevertheless, they are determinants of price and volume, which do drive our models. We will see how this economy and these elements come together to drive prices in the coming year.

Market Update

Markets moved into the second week of earnings announcements looking for signs that inflationary pressures will soon pass and the economic recovery hold up. Reports out of China showing much slower growth kicked off the week. But investors shrugged off the news rising +0.3% Monday. Tech/consumer stocks fared even better, more than doubling the return of the broader market. Stocks posted a +0.7% lift Tuesday with earnings from Johnson & Johnson (JNJ), Travelers insurance (TRV), and Procter & Gamble (PG) encouraging investors that companies have substantial pricing power to lessen the impact of rising costs. A sixth straight day of gains Wednesday with oil prices pushing higher for a fifth day. Stocks added +0.4% while interest rates also continued to march upward. Further strength for stocks Thursday with another +0.3% rise leaving stocks at record high levels. Earnings from Tesla (TSLA) added to recent optimism. Interest rates finally ticked lower Friday after having risen from 1.3% to 1.7% in the 10-year U.S. Treasury yield over the past month. Stocks fell back Friday after seven days of gains. Weak earnings from Intel (INTC) and Snap (SNAP) sapped some investor enthusiasm. The drop in Snap rippled across the digital advertising landscape as the company blamed weaker revenue results on a recent change in Apple’s app store policies. The reduced ability to track user information is seen as perhaps a bigger hurdle for digital ad growth than previously thought. Finally, a ‘blank check’ company linked to Donald Trump’s new social media network registered an astounding +800% gain this week, demonstrating once again the power of retail investors.

Stocks continued building on their newfound strength this week, despite sour news on growth from China and a sharp rise in interest rates. The S&P 500 (SPY) rose +1.63% with nary a downtick over the past 8 trading sessions. The Nasdaq 100 (QQQ) lifted +1.40%. Smallcaps (IWM) added +1.00% but remain range-bound.

Warm wishes and until next week.