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Rising Earnings Do Not Always Drive the Market Higher by Jes Black

http://www.forexnews.com/AI/default.asp?f=A20030725A.mgn

Earnings season is half over and so far second quarter earnings have exceeded estimates by the widest margin in three years. Lower interest rates have fueled consumption while a falling dollar and layoffs have improved the bottom line. A continuation in this trend may very well deliver the highly anticipated recovery in earnings for Q3 and Q4, now forecast at 13.5% and 21% year-over-year growth for the S&P 500 companies.

But do rising earnings always drive the market higher?

Conventional wisdom suggests that earnings expectations drive stock prices and that the market continuously discounts performance. While this rationale dominates each quarter’s earnings spectacle, history suggests this way of thinking is more suitable for individual stocks than index investing.

Of course, in the long run winning companies make more money than they lose, investors are attracted to their rising earnings and share prices reflect this. Therefore, it is encouraging to see that quarterly earnings for the S&P 500 companies that make up this index have nearly always delivered rising earnings. In fact, since World War II earnings have kept pace with the long run growth rate in GDP.



This means the “buy and hold” strategy of index investing should eventually pay off. But looking at the above chart of earnings and GDP growth would leave one to believe the stock market traded sideways from 1947 to 1965 then soared in a raging bull market until the early 1980s as earnings rose at a dramatic pace. But we know this to be exactly opposite the historical market performance. In statistical parlayance, the correlation here is negative.



Instead, stocks rose nearly 600% from WWII until 1965, with a modest doubling in earnings over that period. Yet earnings rose threefold during the 1965-1974 bear market, despite stock prices ending below their 1961 highs. Moreover, most of the earnings gains came in the 1973-74 rout, which was the market’s largest percentage decline since the Great Depression. Earnings then rose in tandem with stocks until the late 1990s when profits began to decline and stock prices still surged ahead.

One might argue that the inflationary 1970s and tech-bubble 1990s were just an aberration in the trend of rising earnings and stock prices. But they are not. The boom, bust sequence continues to drive the business cycle whether the monetary monsters are of the inflationary or deflationary kind. More importantly, in the past century two periods of historically overvalued stock prices were followed by a languishing market despite a swift recovery in earnings.

Therefore, investors should disregard volatile earnings expectations when estimating future trends in the broader market. A more appropriate strategy for general market timing is one that focuses on historical valuation, leaving short-term market gyrations for speculators.

Market Valuation Matters Most

Looking at the price to trailing earnings in the S&P sheds light onto why the previous correlation between earnings and stock prices is so unreliable.



Since earnings in the aggregate simply reflect the long run steady growth potential of the US, in essence, overvaluation can lead to a prolonged period of stagnant stock prices despite ever rising earnings growth, as seen in the 1965-1975 period. Moreover, if earnings are rising at a constant pace then gyrations in the P/E ratio may simply be a reflection of investor psychology, not earnings.

Investor sentiment has a cyclically manic nature to it, running the gamut of underinvested and unloved to overinvested and overvalued. Ultimately it is the collective disposition of investors to buy stocks that stretches valuation to extremes. Here the historical average is 15, representing fair value.

From a contrarian perspective major peaks and troughs in investors confidence mark key turning points for the long-term investor and should be heeded. Using this approach would have unequivocally led you away from stocks in 1929, 1965 and the late 1990s while back into stocks in 1942, 1975 and 1982. Timing these major trend changes makes for successful index investing over the long run.

Meanwhile, the most far-reaching stock market mania in history drove all standard measures of valuation to extremes. If previous trends hold true the stock market may continue to fall even if earnings recover in subsequent years. Moreover, given that the current P/E ratio of the S&P 500 is equal to the 1929 peak, stock prices may have a long way to fall before showing a favorable buying opportunity.

In conclusion, quarterly earnings are both necessary and informative but should not be slavishly followed by the index investor. History suggests that stock prices might actually fall for many years if the previous valuation levels reached an extreme, regardless of future earnings expectations.

-July 25, 2003