Why Earnings are the Biggest Risk to Markets Right Now

US dollar

The markets are at record high values right now, while volatility has seemingly disappeared. All the good news has been priced into stocks, while bad news doesn’t appear to be reflected in most industries. While the third quarter of earnings statements is well under way, all eyes are already focused on what year-end results will be.

Earnings is the primary driver of stock prices. Earnings are then combined with a multiple placed on stocks relative to risk, helping create a stock price. This relationship creates one of the most common ratios investors use to value stocks – the price-to-earnings ratio, or P/E. But with investors seemingly oblivious to risk, earnings results are more critical than ever to keep the bull market alive.

Illusory gains or real growth?

If investors ignore the risks facing the market, earnings become the only real foundation to support higher stock prices. As long as earnings come in as expected, or better yet, higher than expected, then the price of the stock will stay the same, or go down relative to its intrinsic value as determined by the multiple investors are willing to pay.

Assume a stock is trading at $20 per share and has earnings of $1 per share. This gives the stock a P/E ratio of 20. If earnings go up to $1.50, the P/E either drops to 13.33 and the price stays the same, or the P/E stays the same and the price climbs to $30 per share. However, the reverse is true if earnings fall.

If earnings do start to pull back, investors will need to either let stock prices fall to accommodate the suddenly higher P/E ratios, or take on more risk in order to keep prices moving higher. If the latter happens and risk increases in the markets, the danger of a sudden and decisive correction downward becomes more likely.

One of the most concerning issues acing markets going into 2018 is the state of the energy industry. Oil prices have largely been driven by OPEC’s production cut deal in order to reduce inventories and reduce supply. But demand for energy going forward is a telling statistic. Oil prices are expected to hold flat for the foreseeable future and demand for energy isn’t growing significantly stronger. That could be an expected slowdown in global economic growth – something that would translate to lower earnings in 2018.

The stock market can still post gains, even if earnings fall. Historically, the market can sustain higher than average P/E ratios and march forward for years before correcting downward. Year-end results and U.S. GDP will help investors take stock of where the economy is really at in terms of strength and momentum. Other than earnings, other risks, like geopolitical tensions with North Korea, could become more prominent in the short term, as well. Moving forward, investors should use caution when estimating future earnings growth and stock values.