Lesson from '87: Pain can lead to gain
In the wake of Friday's drop, look for the market to overreact to future earnings announcements that fall short of expectations.
Michael Driscoll remembers "Black Monday" of 1987 as the day he made the biggest killing in his 28 years of trading stocks for investment banks and hedge funds -- and the day he was convinced he was going to collapse and die of a stroke under the pressure, at the tender age of 26.
In contrast, Driscoll -- now teaching finance at Adelphi University and pursuing a doctorate of education at the University of Pennsylvania -- and his peers may well shrug off the market selloff last Friday, on the 25th anniversary of the 1987 Crash. Yes, Friday's plunge was dramatic -- the biggest decline since mid-June, and the fourth largest of the year, at least in terms of the number of points forfeited by the Dow Jones Industrial Average. But the 1.5% decline in the Dow is measly compared to the 22.6% crash the blue-chip index recorded back in 1987.
Of course, that doesn't mean that the selloff wasn't justified. It seems investors are finally waking up to the fact that analysts' gloomy third-quarter earnings projections were not just done for the fun of rattling our nerves. Certainly, stocks have spent the last three months heading higher, on average, even as analysts have spent the same period of time steadily trimming back their outlook for profits at the companies that they cover. That's simply not logical. Either investors were in denial about the earnings part of the price-to-earnings ratio, or they believed -- for some unknown reason -- that stock prices would continue to gain ground for reasons that had nothing to do with earnings.
That apparent complacency seems to have come to a crashing halt as of Friday, thanks in part to earnings disappointments from heavyweight companies ranging from technology giants Microsoft (MSFT), which announced a 22% plunge in its profits, Google (GOOG) and IBM (IBM) to consumer companies like McDonalds (MCD). Despite the fact that nearly two-thirds of companies are reporting positive surprises, those "positive" surprises are based on estimates that had been cut back over recent weeks, and may well reflect a year-over-year decline in profits. That's why the overall projections still call for the third quarter to be the first period since the recession ended in 2009 for S&P 500 corporate earnings to contract. (Microsoft owns and publishes Top Stocks, an MSN money site.)
Moreover, the aggregate data includes results from a number of financial institutions that posted surprising earnings and bottom-line growth, such as Goldman Sachs (GS), which swung from a loss in the third quarter of 2011 to a profit in the just-ended quarter, and reported hefty growth in revenues as well.
But what really rattles economists is that few of the corporate earnings announcements betray any sign of a recovery in global demand. With the exception of a few companies like Goldman, revenue growth is turning negative, signaling that companies that do manage to book solid profits are doing so by cutting costs, not because the economy is improving. So even if the earnings season does end up with better-than-expected results, that may not be enough to reverse sentiment. And in the meantime, look for the market, in the wake of Friday's nano-crash, to over-react to future earnings announcements that fall short of expectations.
Ironically, this may begin to create some fresh investment opportunities. At present, the consensus among analysts appears to be that the third quarter will mark the trough in corporate earnings, and that both profits and revenues will recover during the fourth quarter. One current source of anxiety, the eurozone's fiscal and banking crisis, appears to have taken at least a tentative step further in the direction of resolution with an EU summit commitment to move forward with a banking union proposal and a surprisingly successful Italian government bond auction.
It's always darkest just before the dawn, or so the old cliché has it. Ask any veteran investors --including survivors of the 1987 crash -- and you’ll be told the reason it has become a cliché is that very often, it's right; that the time to be a buyer is when everyone else is busily panicking and selling. After the Black Monday 1987 plunge, it took until January 1989 -- 15 months -- for the Dow Jones Industrial Average to fully recover its loss from that day. But it did recover that loss, and would go on to gain another 27% in the next 15 months.
True, you don't want to "catch a falling knife," as another cliché puts it. Certainly there are plenty of reasons to remain anxious about what's going on in the macro environment and what impact that might have on stock prices, from the looming "fiscal cliff" to China's wobbly growth rate.
But to the extent that bearish sentiment comes to dominate the markets, this might be the time to look around for gems that exist in every environment -- companies that are likely to fare well because they are delivering precisely what buyers feel or know they need, whether it's an iPhone or a treatment for cancer. Go past the raw numbers and read the comments that companies make about their future prospects; pay attention to whether CEOs and CFOs appear upbeat (and not just in a defensive way) during the conference calls that follow each earnings release. Odds are you'll be able to identify at least some companies that are worth picking up during the midst of any selloff, as well as those who will continue to fare even worse than the broader market.
Suzanne McGee is a columnist at The Fiscal Times. Subscribe to The Fiscal Times' free newsletter.
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