After Record Profits, the Stock Price... Falls?
Earlier this year the automaker Ford announced a 2010 profit of $6.6 billion, its largest since 1999. The stock market’s response? Ford shares fell more than 12%.
How can the biggest profit in 11 years cause a stock to drop? The explanation is found in a single word: expectations.
Wall Street talks in “future speak.” A stock’s price rises when investors believe that a company is going to generate a profit. And it falls when investors believe losses will occur. The stock market indicates the performance of a company six to nine months in advance — and that’s why the stock market is called a leading economic indicator (as opposed to a lagging or coincident indicator); stock prices are telling us what investors think will happen, rather than what did happen or is happening.
This explains the drop in Ford’s stock. Investors were expecting the company to do well — so well that they had bid the price of its shares to a level that would be justified only if profits came in higher than $6.6 billion. While Ford’s profit was phenomenal, Wall Street was expecting it to be even bigger, and when it wasn’t, investors reduced the price of the stock to correct for Wall Street’s overenthusiastic expectations. This is known, to no surprise, as a market correction.
This is why we do not recommend that you buy individual stocks. An environment where share prices can fall on good news makes it difficult for ordinary investors to know what to expect. That’s why we prefer that you own a diversified portfolio. Instead of betting your life savings on Ford, you can own every automotive stock. In fact, you can own every stock of all industries, not just automotive. Heck, go even further and own all stocks, even those not in the industrial sector. The more you diversify, the lower your risks — and managing risk is as important as seeking return.
Diversification does not guarantee a profit nor protect against a loss in a declining market.