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  1. Home
  2. / Investing

Here's the Line of Thinking You Should Be Using in Your Investing Outlook

What could wrong? Well, everything.
By JIM COLLINS
Dec 03, 2020 | 12:20 PM EST
Stocks quotes in this article: TSLA

What could go wrong? It is the eternal question, and for those long stocks, it should be asked everyday. Similarly, those who short stocks have to ask "what could go right" every day, and in the second half of 2020, the answer has been "everything." But, as usual in a market filled with commentators blathering on some financial news networks and with no real analysis, the answer to either of those "what could?" questions are nearly impossible to answer today.

But the prevalence of information on the Internet gives the individual investor the ability to perform a higher level of analysis. Just doing what everyone else does is a tried-and-true method of investing, and measures of market sentiment are decades old and have held up fairly well. But I am not sure we even need those in 2020. Just pull out your phone, click on the app of your choice, and you will know EXACTLY what the market is saying today.

But that's not how to make money over and above the systemic risk that one assumes by owning stocks at all. This is what we analytical nerds call alpha. As my director of research at DLJ used to say, "investing is about the second derivative." Generating alpha requires the ability to spot trends and, even more importantly, spot when those trends are changing. The market never does this in real-time, and that's where the alpha is made. As a former sell-side analyst, I can tell you that there is very little -- at DLJ there was some, but that firm hasn't existed for nearly 20 years -- to no incentive for an analyst to call an inflection point. Just keep jacking up price targets, using ridiculously long-term predictions to come up with bogus discounted cash flow valuations, and keep the investment banking department happy.

I read research talking about 2030 on a daily basis, and, this morning, I even read a Goldman Sachs piece on Tesla (TSLA) that purported to predict the size and shape of the electric car market in 2040. Seriously? No one can see 20 years into the future. "Research" like that is just a joke, and who would believe it, let alone write it.

As I have stated in prior columns, I use the work of John Butters at FactSet on a regular basis. John doesn't wield a 20-year-forward crystal ball, he simply compiles earnings estimates from sell-side analysts and presents them in a very useful form. There was no FactSet Earnings Insight last week owing to the holiday, but using the 11/20 version, several easy comparisons can be drawn.

- Third quarter 2020 earnings for the S&P 500 were better than expectations, they almost always are, an average, but still showed a decline of EPS for the S&P 500 of 6.3%, the continuation of the first two-quarter decline in earnings for the Index since 2016.

- Market analysts are calling a MAJOR inflection point for S&P 500 EPS in 2021. Here are the estimates, as compiled by Mr. Butters.

4Q2020 (-10..6%)

1Q2021 +14.6%

2Q2021 +44.0%

3Q2021 + 21/9%

There you have it...if you are gullible enough to believe the world is going to "snap back" into normalcy in 2021. As of the last published issue of Earnings Insight (the next one will be released tomorrow) the S&P 500 was trading at 21.7x forward 12-month earnings, well above the 10-year average of 15.7x. Given the markets' rally in the past few weeks and the tendency of future period earnings estimates to be lowered as the future approaches, it is reasonable to say we are trading at 25x next year's earnings now, clearly a valuation high-point since the 2008 Crash.

We are at a cycle-high valuation, and the world faces rising Covid-19 case figures (at the margin - always look at the second derivative.) and the risk of more draconian, ineffective lockdowns, as we saw from Los Angeles Mayor Garcetti this morning.

What could wrong? Well, everything. You should be using that line of thinking in your investing outlook. It is nearly impossible to short anything against the flood of money being printed by Central Banks and being handed out by federal governments (inducing ours), but there are opportunities at these levels. I will have some of them in my column tomorrow.

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At the time of publication, Jim Collins had no position in the securities mentioned.

TAGS: Investing | Markets | Stocks | Trading

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