If you're a new investor, you probably make this mistake. Heck, if you're a seasoned veteran, you may still make this mistake from time to time...
You think that a growing or profitable company always makes for a good stock.
After years in the markets, I have learned this is simply not true.
The problem is that growing profits are already reflected in the price of a stock. It doesn't matter what a company has done for the past 10 or 20 years... or even what it's doing today.
All that matters is what a company is going to do.
This is especially important to understand this year. Let me explain...
You see, the market is priced on expectations of the future. To outperform, you need to find stocks that will grow at a higher rate than the market expects.
Take Apple (AAPL)... It's one of the most profitable companies in the world by net income. Everyone knows Apple makes gobs of money.
But this month, Apple warned its suppliers of weakening demand for some of its key products. According to news outlet Nikkei Asia...
In a sign of the gloomy outlook for consumer electronics, Apple has notified several suppliers to build fewer components for AirPods, the Apple Watch and MacBooks for the first quarter, citing weakening demand.
Of course, this is troublesome for an Apple shareholder. You want to see demand increasing, not the other way around.
But this doesn't mean Apple is losing money. Far from it...
The company will still earn around $110 billion in free cash flow – the purest measure of profits. It will also pay the same dividends and buy back the same number of shares as it has in past years.
Even so, shares fell about 4% the day of the announcement. The company shed $77 billion worth of market value... all because the outlook for future earnings had dropped a bit.
Nothing has fundamentally changed about Apple. It's still one of the best businesses in the world. And, as I pointed out, it will still make lots of cash and reward its shareholders. But sentiment has changed.
The collective feelings of market participants have assigned Apple a different price. In August, investors would pay about 28 times current earnings for the future of Apple. Today, they'll only pay 22 times earnings.
It's the same with stocks in general. The S&P 500 Index has reduced its valuation from 21 times earnings to 19 times earnings.
Right now, markets are pricing in recession. Investors are scared... And those expectations have shown up in valuations.
Manufacturers are also expecting contraction ahead...
You see, heavy industrial businesses aren't like consumers. They don't buy more or less in a given month because of their optimism, tax refunds, bonus season, or the weather.
Industrial corporations plan months to years in advance. They carefully weigh potential returns and capital costs. They only start expanding when they're highly likely to be profitable. To measure how the industry is doing, we look at the Institute for Supply Management's ("ISM") Manufacturing Purchasing Managers' Index.
The Purchasing Managers' Index ("PMI") surveys executives in manufacturing. A reading above 50% means growth and expansion. A reading below 50% means contraction.
The December reading came in at 48.4, the lowest since the start of the COVID-19 pandemic. Take a look...
With so much negative sentiment in the air, strong companies may find it easier to beat expectations. The market is already pricing in a recession... And any surprises to the contrary could be extremely bullish.
If you're going to navigate this market in 2023, make sure you're aware of expectations. It's one of the best secrets to investment success.
Here's to our health, wealth, and a great retirement,
As an investor, you don't want to follow the crowd. The popular outlook is often wrong – especially at critical moments for the market. Our colleague Greg Diamond says right now is one of those times... Learn more here.
"Mom-and-pop investors want nothing to do with stocks," Brett Eversole says. One measure from a major brokerage shows just how fearful folks are today. And importantly, history suggests this is an incredibly bullish sign for contrarians... Read more here.