Posted on March 15, 2018 in

For Long Term Investors, Earnings Still in the Driver’s Seat

The first major stock market correction in over a year appears to be in the rear view mirror, but many investors are still nervous. Market commentators have decided to declare that “interest rates” were responsible for the initial drop in early February, and the President’s announcement on trade policy and tariffs was the reason for the second drop later in the month.

It is important for long term investors to understand that the reasons for corrections are always assigned after the fact, and that it is usually a mistake to make long-term investment decisions based on short-term market fluctuations.

Earnings are still the key to understanding stock prices

In the long run, fundamentals still drive the markets. Historically, stock prices have followed corporate earnings growth. When companies grow, and increase their profits, stock prices will follow. Research shows a company’s track record of stable earnings and future earnings growth prospects, are two of the most important factors investors should consider when making long term investment decisions.

In the fourth quarter of 2017, more companies beat earnings expectations than at any time since the Great Recession in 2008. Analysts expect earnings growth to continue this year. The recent tax cuts should provide an earnings boost, and continued economic growth will also be positive for corporate earnings.

No signs of an imminent recession

Economists gather data from many places to gauge the overall health of the economy. Factors like unemployment, wages, inflation, interest rates, debt levels, investment activities, and industrial production all provide information on how the economy is really doing. So far this year, all of these factors point to continued economic growth.

Consumer credit is at historically normal levels. In the past, household debt often rose sharply before a recession. Capital expenditures – a measure of how much companies are investing in property and equipment – are in an uptrend, and manufacturing activity is also in an uptrend. Long term interest rates are higher now than they were a year ago, but interest rates are still at historically low levels. Inflation remains slightly below the Federal Reserve’s 2% target. The economy is continuing to create jobs at a healthy pace, and overall unemployment is the lowest it’s been in years. These factors combine to paint a picture of a healthy economy, despite the stock market’s recent volatility.

In the short run, the market correction could continue. Based on history, it wouldn’t be surprising if it takes many months before the major indexes again make new highs. Investors who expect a quick return to the steady upward march we saw last year might be disappointed.

If the economy is good and growing, well-run companies will continue to make money and increase their earnings. Long term investors should look past the short-term fluctuations of the markets, remain mindful of the factors that matter most, and stay focused on the fundamentals.