Fundamentals and investor sentiment are two key drivers of the stock market. It’s important to understand how the market responds to both these factors, but also how fundamentals like price/earnings ratios and earnings per share eventually validate stock prices.
Understand the relationship between investor sentiment and fundamentals
It can take years for fundamentals to validate asset prices
Here’s a common thought that pops up amid market uncertainty: “If I can’t figure out what’s driving the stock market, then I can’t tell whether the market’s moving too far ahead, too far behind, or right on pace with whatever is supposed to be driving it.” Well, that’s a pretty intelligent reflection. If you don’t know what’s driving the market, then doesn’t that mean you’re lost?
Quite possibly. So, to figure out where you are, where the market might be, and how to keep up with it at whatever speed it’s moving, a first step is to know how the market works.
Ask a fundamental analyst what drives the stock market and you’re likely to get a bunch of metrics: price/earnings (P/E) ratio, price/book (P/B) ratio, earnings per share (EPS), price/sales (P/S) ratio, return on equity (ROE), and plenty more. Notice how they all have to do with numbers.
These numbers make up an important part of a stock’s fundamentals, or the valuation of its price in relation to measurable economic factors. This is the rational side of the market; it estimates where a stock’s price should be based on the broader economy.
But markets are dynamic, fluid, and often anything but rational.
Markets can move on sentiment, which is driven by human fear, greed, FOMO (fear of missing out), and even indecision or ambivalence. These have little to do with “the numbers” and are more about estimation through feeling, gut response, intuition, or worst of all, impulse. Sometimes tracking sentiment works; other times it doesn’t.
At any rate, these are the market’s two primary drivers. Want to know if the market is getting ahead of itself or falling behind? Watch fundamentals and sentiment. Eventually, they’ll have to sync up, because fundamentals have the final say.
Let’s look at the idea of fundamentals versus sentiment from a personal perspective. Suppose an employer hires you, investing in your talent, skill, and capabilities. After a few months, suppose you have successfully completed every task assigned to you. Your manager comes to expect that you’ll complete every task on time. You may even need to do something extra to keep up that positive sentiment. On the other hand, maybe your manager doesn’t think so highly of you, even though you have been reliable. But if you keep working hard and keep completing your tasks on time, your manager’s sentiment should improve and converge with the reality, which is that you are a consistent performer.
This applies to stocks as well, but with a more flexible time horizon.
If the stock market is soaring, the fundamentals must eventually validate the price. Sentiment may show that people favor a given stock, but the fundamentals must show why people value that stock. Here’s the tricky part: this validation can take months or even years, depending on how far out you’re willing to project.
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Consider stock market trends. From January to December 2019, the S&P 500 rose nearly 25%. If you tuned into financial media, you might have noticed some pundits claiming that the stock market was getting ahead of itself while others were saying it was right on pace with the economy.
Who was right? Well, you’d need to see some impressive earnings to justify the rise in asset prices. Perhaps investors and analysts were expecting this justification in Q1 or Q2 of 2020.
Then, COVID-19 happened, and the markets got all out of whack with a new and unprecedented quandary.
So now we wait while the pandemic adds new factors to the fundamental mix, making the situation even more fluid as it continues to develop. As of March, the broader stock market had “reflated” itself:
Remember, P/E ratios reflect what the market is willing to pay for stocks based on their past or future earnings. The trailing P/E is a 12-month average, while the forward P/E estimates what earnings might look like in the future.
Is there sunshine ahead? It depends on “actual” earnings figures.
There are other ways to assess company valuations, such as the price/sales ratio or enterprise value. Let’s talk about the latter metric. Because of the pandemic, companies are likely to face higher debt. Enterprise value—market cap plus net debt compared with EBITDA (earnings before interest, taxes, depreciation, and amortization)—could be a more useful valuation measure.
There’s a saying attributed to the economist John Maynard Keynes: “Markets can stay irrational longer than you can stay solvent.”
This is a warning for anyone taking a large contrarian position against prevailing market sentiment, especially the “shorts” who were bearish throughout the last bull market.
It can also mean you should prepare yourself for rational thinking not to play out for some time, even several years.
Remember, the proof is in the fundamental pudding, that is, earnings. But you might have to wait a bit to be served. In the meantime, you may not want to change your long-term portfolio strategy. Consider purchasing small chunks of shares with a diversified approach or using dollar-cost averaging to acquire discounted shares when the market tumbles.
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