A Good Week for Netflix
US equities finished the week sharply higher, rising 1.7%. Communication services led the way, supported by surprisingly strong results from Netflix NFLX which rose 14% over the week and Meta Platforms META up 5.9% ahead of results on Wednesday. Despite this strong rise, Meta continues to be priced near Morningstar’s estimate of its fair value with the Communications Services sector as a whole is priced at a slight discount. You can find out what Morningstar’s Meta analyst Malik Ahmed Khan is expecting from these results here.
Healthcare Stocks Still Undervalued, For Now
Healthcare was the second best performing sector as recent results from Johnson & Johnson JNJ and UnitedHealth UNH indicated that investors have been too pessimistic on this sector. Although healthcare companies have started the year strongly, halving the discount to fair value that we saw at the end of 2024, the sector continues to be priced below fair value, providing opportunities for those who wish to be selective in their investing.
Exxon Mobil’s Earnings Incoming
In contrast to the trend over recent weeks, energy stocks acted as a drag on the market, falling 3% ahead of results from Exxon Mobil XOM on Friday. Accounting for over 26% of the energy sector and priced at a deep discount to Morningstar’s estimate of its fair value, these results will be a test of the low expectations surrounding energy companies. You can keep track of these and other results on Morningstar’s dedicated company earnings page.
Why Profits Are Cylical
Strong earnings results are particularly welcomed by investors when stock prices are high as they appear to convert optimism about the future into solid historical financial results. In doing so, they lower commonly followed valuation metrics such as the price/earnings (P/E) ratio and encourage greater optimism among investors. However, it is important to recognize that profits are typically cyclical with some companies closely linked to the broader economic cycle and others less so, but few are immune to cyclicality over the long term.
This lesson is painfully learnt each time we experience a long period of secular growth in an asset class or group of companies as investors eventually come to believe that these assets are immune from the cycle and ascribe unrealistically high valuations and earnings estimates to such assets. Even in the absence of a boom, company valuations can be more stretched than they first appear using traditional ratios as above average prices are compared to cyclically high earnings.
As earnings decline, companies can appear more expensive when measured using these ratios, despite falling in price. This can encourage those who used these metrics as buying signals when prices were high to sell when prices are much lower, igniting a pattern of capital destruction.
Stock Market Models
To avoid this outcome, it is important to use longer-term valuation methods that account for cyclicality. Such models conform to George Box’s maxim that “all models are wrong, but some are useful.” In this case, such models tend to indicate that a stock is expensive well before it is recognized by the broader market, leading to the sacrifice of short-term gains in the hope of avoiding longer-term losses. However, for most investors this is preferable to the alternative. To find out more about how Morningstar values companies, check out this article by Susan Dziubinski.
No Rate Cut Expected This Week
Wednesday will be especially busy for market commentators this week. In addition to Meta, Microsoft MSFT and Tesla TSLA reporting results and the outcome of the latest meeting of the Federal Reserve will be revealed. While there is an overwhelming consensus that interest rates will remain on hold, the accompanying comments will be scrutinized for hints at the future path of interest rates. The current consensus among forecasters is for one or two interest rate cuts over the year. Any serious challenge to this view is likely to cause volatility in the equity and bond markets. You can find all of the earnings and economic news due this week in this calendar.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
