Value Line University

Expectations

Professional analysts and individual investors tend to change their expectations about individual corporate earnings in response to new information about the health of the economy in general.

If investors expect boom times, they are often willing to pay increasingly higher prices across the board for stocks. But if they expect a recession to occur, they expect that many businesses will suffer slowdowns and earn less money. Stock valuations are likely to drop.

For example, if the economy is weak and people are being laid off, or are afraid of being laid off, they are less likely to be buying new cars. So investors will lower their expectations for automakers' earnings. Similarly, if fewer cars are being manufactured, automakers will buy less steel. That means steel companies can be expected to earn less.

How does that translate into investment decisions?

In this scenario, the stock prices of automobile and steel manufacturing companies are likely to decline as investors shy away from them.

In a serious recession, prices of stocks in vulnerable sectors will continue to drop and drag the entire stock market down. But in a more typical situation, when the price drops to a certain level, investors once again see the company stock as a promising opportunity to make money and begin to buy again. A parallel situation typically develops with the automobiles themselves: Since they are not selling, the company lowers the prices. In all but the worst economic conditions, that encourages people to buy. An upward swing of the economy begins and investors who have bought stock in the automobile company when its price was depressed see the price begin to climb.

Investors also know that every business is not affected equally by a recession. Even in a recession, people still brush their teeth. So the earnings of companies that manufacture toothpaste probably won't suffer as much during a recession as those companies in the automobile and steel sectors. That means that their stock prices aren't likely to drop as far and may even remain strong since they represent one place to make money unless the economy as a whole slips into a deep recession or a depression.

On the other hand, when times get better, people don't brush their teeth any more than they did when times were bad. So unless the toothpaste company can introduce new products or increase the price of the toothpaste significantly, its earnings are not likely to increase in a boom period as rapidly as earnings in more cyclical industries.