Traders have a well-known mantra: buy the rumor, sell the news. The basic idea behind it is that markets move on expectations, so once the expected event unfolds, it's time for the trader to move on. It was in this spirit that a friend of mine asked me last week if it was time to "sell the news." The news he was referring to, of course, was the mid-term election.
While my friend had the mantra right, I think he was looking at the situation all wrong. The mid-term election was not a trading opportunity because it was not driving the market. If anything, the elections - from an economic point of view - were a sideshow, something to keep the crowd entertained during a lull in the main event. The main event is the economy's nascent growth and the associated growth in corporate profits. Let me show you what I mean.Since the mortgage crisis, investors have become extremely pessimistic, Because of their pessimism, investors have cut way back on the amount they are willing to pay for a dollar of corporate earnings. The amount investors are willing to pay for a dollar of earnings is known in market circles as the "price-earnings" or PE ratio. As you can see in the preceding chart, the PE ratio is currently well-below its average since the late 1980's.
Now think about what happens as corporate earnings come in higher than expected. First, the market tends to adjusts higher to keep the PE ratio constant. Second, as investors realize that earnings are better than they feared, they begin having greater confidence in future earnings. As their confidence expands so does their willingness to bid for a dollar of earnings and the PE multiple expands.
With the PE ratio at its lowest levels since 1994, there is plenty of opportunity for the market to go dramatically higher. In fact, if the PE multiple were to expand to its average reading of 19.2 times current operating earnings, the index would increase by 33 percent. With this kind of main event on stage, wise investors will stay invested and ignore the "sell the news" sideshow.