Investors need to be aware of a significant dynamic emerging in the markets.
That dynamic is one of corporations missing revenues estimates while beating earnings estimates.
The majority of investors focus on earnings when it comes to valuing the stock market or an individual stock. Indeed, Price to Earnings or P/E ratios might be the single most popular stock valuation metric in the world.
However, there is a danger to pricing the market based on earnings alone. Earnings can be massaged in countless ways to beat estimates. You can release loan loss reserves, massage depreciation numbers, implement one time charges or writedowns, reprice bonds, etc.
Indeed, a study performed by Duke University found that roughly 20% of publicly traded firms manipulate their earnings to make them appear better than they really are. The folks who were surveyed for this study about this practice were the actual CFOs at the firms themselves.
For this reason, when you look at the markets, you need to look at how many companies are beating sales estimates as opposed to simply earnings estimates.
Unfortunately the news is not particularly good for this today. As Bloomberg notes, of those companies who have reported results so far in 3Q13, only 38% of S&P 500 companies are beating revenues estimates. This follows just 46% who beat in 2Q13 and only 37% who beat in 1Q13.
Bloomberg notes that this is the first time there have been three consecutive quarters of less than 50% of corporations beating revenues estimates going back to 2009.
Moreover, taken as a whole, the market is trading at a Price to Sales ration of 1.6. Historically, before we entered the period of Fed-induced serial bubbles, the market has traded at an average of 0.8.
So the market is expensive. And the most sensitive economic indicator (sales) are falling and failing to beat estimates.
But this doesn’t mean there are no incredible opportunities to make money in the markets today.
It does mean that investors will have to look beyond simply “buy and hold” strategies (the P/S ratio predicts real annual returns of 2.6% going forward) to accomplish outsized returns.
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