The stock market seems mysterious at first glance. Prices move up and down, seemingly based on the whims of traders. There is a sense of disorder in the price movements. Since many individuals prefer order to disorder, there have been many efforts to find order in the markets.
Much of the effort has been focused on price patterns. The goal here has been spotting recurring patterns in price, including famous patterns like a head and shoulders pattern. These patterns have some value and are often based on principles of behavioral economics.
But, price patterns are subjective and often prone to misinterpretation. The fact that they are subjective may very well be the cause of their failure rate.
As noted, patterns like the head and shoulders have a sound theoretical basis. Behavioral economists have found that investors tend to overreact and underreact, and these behaviors can explain the existence of the pattern.
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But, when analyzing charts, individual traders will have a bias about the market. They may be bearish and therefore see signs of a market top in every chart they look at. Or, they may be bearish and ignore the risks evident in many patterns.
Despite the shortcomings in interpretation, patterns should play an important role in the analysis of markets.
Profit Patterns Underlie Capitalism
Economists have studied profits because they explain business expansion, contraction and failures. Ultimately, the goal of entrepreneurs is to generate a profit. This is obvious and should lead to certain patterns.
We can evaluate profits with a measure such as return on equity (ROE). The ROE is a standardized measure of profitability. It is the ratio of net income to shareholders equity, expressed as a percentage. It shows how much profit a company generates with the money shareholders have invested.
The formula is simply net income divided by shareholder’s equity multiplied by 100 to state the value as a percentage. This means it is directly comparable for all businesses regardless of size or industry.
In theory, an entrepreneur reviewing potential business opportunities will consider the ROE of each option and select the one with the highest ROE. This assumes the business is affordable, of course, and something the entrepreneur is capable of.
While it is possible a software company offers the highest ROE, not all individuals are capable of starting a software company. This analysis assumes funds and talent requirements are approximately equal for the different business opportunities.
Over the long run, there will be an average ROE for an industry, When the ROE is above average, we would expect new businesses to enter that industry. As new businesses open, the level of competition increases and the companies in the industry will be forced to compete with price cuts.
Eventually, the new entrants will force the ROE down, eventually to a below average level.
When the ROE is below average, some of the weaker businesses will no longer be profitable. They will leave the industry and as the number of businesses decline, prices should then rise, and the ROE should increase.
This cycle of a rising and falling ROE can be seen in the following hypothetical ROE curve shown below.
When ROE is high, competition in the industry will increase. When it is low, competition will decrease. In other words, ROE is what economists call mean reverting. At least in theory. The next chart shows the real world data and the theory holds up.
That chart shows the ROE for the companies in the S&P 500 over the past twenty years. It is not precise but there is a cyclical pattern present in the data.
Profits Impact Prices
This demonstrates that profitability affects prices of products and services since high ROE should lead to price cuts and low ROE should result in higher prices over time. Sales are, of course, the top line of a company’s income statement. Therefore, it’s logical to assume there should be a profit pattern in stocks.
The next chart compares the ROE of GE with the stock price of General Electric Company (NYSE: GE) over the past twenty years. The relationship is far from precise but there is a correlation in the direction of the trend of the two data series.
In the chart above, the stock price is the solid line and the ROE is shown as the columns. ROE is updated once a quarter since that is when financial statements are released.
For GE, and for other individual companies, the direction of changes in ROE will often mirror the direction of the long term trend in the stock price. GE has been a company that has seen its financials deteriorate over time, and the stock price has also been in a long term down trend.
Putting Profit Patterns to Use
So far, we have that economic theory tells us to expect profit patterns that can be visualized with a metric such as ROE. We have also seen that this pattern shows up, in the long run, in a stock’s price pattern.
Profits affect stock prices in the long run. In the short run, a stock price does move almost randomly. If price moves were perfectly random, we would expect to see prices close higher about 50% of the time and lower 50% of the time.
Over the past 52 weeks, NVIDIA Corporation (Nasdaq: NVDA) has been the best performer of all stocks in the S&P 500. It has gained more than 200% and closed up 56% of the time. The worst performer, Frontier Communications Corporation (Nasdaq: FTR), lost over 80% and closed down about 56% of the time.
While prices in the short run aren’t precisely random, they are difficult to predict. However, the direction of the trend is easier to predict over longer time frames and this can be seen on a price chart. This is because price changes, in the long run, reflect changes in profitability.
That provides a useful insight for investors. If you are truly investing for the long term, it will be important to own stocks that are reporting positive changes in fundamentals quarter after quarter. This is important to finding long term winners.
For example, an investor could limit long term investments to companies reporting increases in sales and earnings per share in each of the past three years. Or, they could use ROE and require that the metric be higher in the past quarter compared to a year ago and in ten of the twelve previous quarters.
Since it is a long term trend that is being invested in, the trend needs to be measured over the long term. The decision to sell should also consider fundamentals if they are a reason to buy. For example, declines in ROE for two consecutive quarters, or more, could trigger a sell signal.
If your focus is on the shorter term, fundamental patterns could still be useful. You could, as one example, limit buys to companies reporting increases in sales and earnings in the past year. In this case, a change in trend in just one quarter could be a sell signal.
Fundamental patterns should not be ignored by traders. The fundamentals of GE, as shown above, have been in decline for some time. Yet value investors have been attracted to the company over that time believing the decline in price presented a buying opportunity.
Looking at patterns in GE, sales have declined an average of 4% a year over the past five years. Earnings fell an average of 5% a year over that time. Free cash flow declined more than 60% and ROE fell 18%.
For NVDA, ROE tripled while sales grew an average of 11% a year, earnings growth averaged more than 20% and free cash flow grew an average of almost 9% a year.
Trends in fundamentals are important to a company, and the stock and should never be ignored.
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