Expectations are a part of the game.
As expectations change, so do the markets. What could be simpler? Markets are discounting mechanisms, so why aren’t expectations the whole game?
Expectations are the whole game for widely traded assets that are analyzed by many. But there are complex assets and smaller assets for which expectations, should they exist, are not well-defined. A large example would be Berkshire Hathaway. When the stock of Berkshire Hathaway begins to care about making/missing earnings estimates, that will be a real change in the way the stock is viewed.
I have a number of other stocks in my portfolio that have no analyst coverage, so whatever expectation their is for the company is ill-defined. Earnings shrink? Stay flat? Rise a little, lot, or more? Often the reactions are muted, because expectations are ill-defined.
With cheap stocks, I often view results in two ways:
- Expectations mode: are they beating earnings expectations or not?
- Book value mode: are they earning enough to justify the current market price? (And are the earnings real?)
It’s hard to lose money on companies that trade below book and have a single-digit P/E. The value accretes and eventually market prices follow. You just have to be happy with firms that are boring, but profitable.
Cheap stocks with good balance sheets do not get killed when there are earnings disappointments. With those stocks, we can sit back and wait for a better day.
All that said, earnings estimates provide a feedback mechanism for those stocks that have an adequate number of analysts following them. Imperfect as it is, it guides the way we react to quarterly releases of adjusted earnings. And when companies attempt to show adjusted earnings that are liberal, it is no surprise when the market rejects their presentation, and the stock goes down.
But this rule applies to policymakers as well. Over the last 27 years, the Federal Reserve has placed a greater emphasis on communications. I think that was a mistake, but the Fed made it a goal to shape the expectations of the market. And they did so.
But once you sharpen the focus of the market to your promises, should it surprise you that when you give the least bit of equivocation, that the market reacts badly? Hey, you made your bed, now sleep in it. You trusted in your ability to communicate, and now you reap the result.
Even with no current change in policy, a change in expectations can have a huge effect on markets, particularly when novel policy tools are being used. Ben Bernanke should not have been surprised by the reaction of the market to his comments to the press after the last FOMC meeting. All of the efforts since that time to take it back have bolstered the stock market, but have not affected the bond market much. Remember that the bond market is usually smarter than the stock market, thus I remain bearish.
Full disclosure: Long BRK/B
By David Merkel, CFA of Aleph Blog
