The #1 problem for investors is “information overload.” There are just so many different potential investment strategies to follow. Each of them claiming to be the best route to success. And then you have countless places to get this information: TV, Internet, magazines, books, friends/family, etc.
When you consider this landscape, it’s no wonder the stock market is more volatile these days given all the different forces at work that drive the varied investor decisions.
So let me provide you something to help cut through the clutter and make more profitable investment decisions. The largest single ingredient followed by the largest number of investors is earnings. In particular, earnings estimates. So the more you focus on these concepts the better off you will be.
Why’s that? Because institutional investors still rule the market. These money managers come to play every day with trillions of dollars to spend. Meaning they have the greatest ability to change the shape of the market or the plight of any individual stock.
I am not implying this is a homogenous group of people who all make decisions the same way. They, too, follow many different investment strategies. But by far the most common thread between them is their belief in earnings.
That’s because most money managers are former stock analysts. And most stock analysts are Chartered Financial Analysts (CFAs). These guys get drilled on the fundamentals of investing. In particular, concepts like the Dividend Discount model or Discounted Cash Flow model for valuing stocks. In a nutshell, these models work like so:
If the present value of a company’s predicted future earnings stream is higher than the current price, then more people will buy the stock.
So the main ingredients in this model are earnings estimates and the discount rate. As for earnings estimates, if they go up, then the fair value of the stock goes up (and vice versa).
As for the discount rate, that is the risk-free rate plus a premium for taking risk in the stock market.
With earnings still on the rise for most corporations and the discount rate dropping (because the risk free/Treasury rate is near historic lows), this is the #1 reason for the recent market rally. The good news is that if this earnings season meets or exceeds expectations, then we will continue to rally.
Sometimes it is that simple.
By Steve Reitmeister