In yesterday’s column, I debunked the myth that the stock market is long overdue for a pullback.
You might not believe it, but it’s true!
That being said, I’m afraid many of you walked away thinking that it’s simply a matter of (more) time passing by before a pullback or correction materializes.
That’s not the case, though.
You see, the mere passage of time doesn’t usher in pullbacks. It takes something specific to trigger them.
Or, as Deutsche Bank’s David Bianco says, dips might be inevitable, but “they don’t happen in absence of bad news or emerging risk.”
And right now, there are no emerging risks on the horizon. Don’t just take my word for it, though.
“We’ve got low inflation, improving domestic and global trends, [an] accommodative Fed, and it all adds up to a package that is a constructive backdrop for equities,” says Jim Russell, Senior Equity Strategist at U.S. Bank Wealth Management.
Indeed. That only leaves really bad news as a possible catalyst for a pullback or correction. So what type of bad news could ultimately trip up the stock market?
The opposite of what’s propelling it higher, of course!
Don’t Forget the Golden Rule
Forget a 5% pullback or a 10% correction. Some pundits and investors believe we’re in store for a massive 25% meltdown.
Fear mongers! Or maybe they’re just afraid of violating Warren Buffett’s golden rule of investing to “never lose money.”
Whatever their motivation, it doesn’t matter. The reality is, it’s going to take a sudden drop in corporate profits to collapse the stock market.
After all, stock prices ultimately follow earnings. I know I’ve told you that countless times already. But I’m afraid many of you still don’t believe it.
Maybe you just need to hear it said differently? If so, consider Larry Kudlow’s phrasing: “Profits are the mother’s milk of stocks.”
Too National Geographic for you? Ok. On second thought, maybe you just need additional proof.
Well, here it is, courtesy of Dr. Mark Perry at American Enterprise Institute (AEI).
As Perry explains, a one-to-one relationship exists between stock prices and after-tax corporate profits. For every increase of $1 billion in profits, the S&P 500 rises about 1 point. That is, with two notable exceptions: the dot-com bubble and the Great Recession.
As you can see, stock prices got too far ahead of corporate earnings during those periods. Sure enough, the market restored the relationship between corporate profits and stock prices by collapsing.
Or, put simply, stock prices ultimately followed earnings.
Here’s why all this matters…
According to Perry, “In the current bull market rally… corporate profits are consistent with stock market levels.” So the one-to-one relationship is in full effect. And that means there’s nothing abnormal about the current bull market. Corporate profits are driving stock prices.
By extension, as long as corporate profits keep increasing, stock prices should, too. And that’s exactly what analysts expect to happen…
After rising for more than three years, the consensus estimate calls for profits for S&P 500 companies to keep climbing to hit a record of $109.30 this year.
Bottom line: Absent a sudden drop in corporate profits – or the Fed unexpectedly pulling the plug on its quantitative easing initiatives – a pullback or correction is not going to magically materialize.
Stay tuned for tomorrow, though. I’ll share three key metrics to help you detect any deterioration in earnings – well ahead of the average investor.