We have all heard the phrase “earnings are the mother’s milk of stocks.” I believe the phrase was coined by Larry Kudlow. In fact, I have some commenters to my articles that claim that earnings are the only thing one needs to know about investing in the stock market.
But, is it true?
Bob Prechter has done some research into this topic, and has outlined some very interesting market history that flies in the face of the common perception regarding earnings: The Myth of Company Earnings and Stock Price
Are stocks driven by corporate earnings? In June 1991, The Wall Street Journal reported on a study by Goldman Sachs’ Barrie Wigmore, who found that “only 35% of stock price growth [in the 1980s] can be attributed to earnings and interest rates.” Wigmore concludes that all the rest is due simply to changing social attitudes toward holding stocks. Says the Journal, “[This] may have just blown a hole through this most cherished of Wall Street convictions.”
What about simply the trend of earnings versus the stock market? Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while earnings rose 47%. 12-month earnings peaked at the bear market low. Earnings do not drive stocks.
Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again. But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices. This was certainly true in 2000, as the chart shows. Peak earnings coincided with the stock market’s all-time high and stayed strong right through the third quarter before finally succumbing to the bear market in stock prices. Investors who bought stocks based on strong earnings (and the trend of higher earnings) got killed.
While Bob accurately outlines how earnings are often the strongest at the market highs, which compels earnings followers to be buyers at market highs, what do earnings tell us about market lows?
Well, let’s start by looking at some of the best buying opportunities in recent history. For example, in March of 2009, were earnings telling you this was the best time to buy the market? How about in March of 2020? Were earnings telling you this was also an amazing time to buy the market?
It is quite clear that those two times were among the best buying opportunities we have seen in the last 13 years, yet earnings and estimated earnings were dismal. It actually took a massive rally in the market to be seen before earnings began to turn back up.
While you may be scratching your head as to the facts and reality regarding earnings, let’s consider why this is the case. I have written about this in the past, so I will simply re-post that here:
During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive. You see, once you hit a wall, it becomes clear it is time to look in another direction. Some may question how sentiment simply turns on its own at an extreme, and I will explain to you that many studies have been published to explain how it occurs naturally within the limbic system within our brains.
When people begin to subconsciously turn positive about their future (which is a subconscious – and not conscious – reaction within their limbic system, as has been proven by many recent market studies), they are willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest and most immediate way is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned.
In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.
The most recent example of this is when the SPX bottomed at 2200SPX, and began a rise that has almost seen a double in price despite the worst news of Covid deaths, record high unemployment, and economic shutdowns being reported during the heart of the rally off the low.
Yet, economists still view us as being in a recession today! Do you see what I mean? (This was written after the S&P500 had already rallied 1500 points off the March 2020 lows).
Let's look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, and those take time to secure.
They then put the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public and, ultimately, profits and earnings begin to grow - after more time has passed.
When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals is evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.
Clearly, there is a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change.
This is why I claim that fundamentals are a lagging indicator relative to market sentiment. This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive-mood effects on a business-growth cycle.
It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns. By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time. And this is why economists fail as well – the social mood has shifted well before they see evidence of it in their "indicators." In fact, I want to again ask: Are we not still technically in a recession.
As you may be able to surmise, you are likely going to be left holding the bag at the major turns in the market even if the earnings projections you are using are correct. But, are earnings estimates you are basing your investing even reliable in the first place?
Let’s consider what Daniel Crosby highlighted about earnings in his book The Behavioral Investor:
“[C]ontrarian investor David Dreman found that most (59%) of Wall Street consensus forecasts miss their targets by gaps so large as to make the results unusable – either undershooting or overshooting the actual number by more than 15%. Further analysis by Dreman found that from 1973-1993, the nearly 80,000 estimates he looked at had a mere 1 in 170 chance of being within 5% of the actual number.
James Montier sheds some light on the difficulty of forecasting in his “Little Book of Behavioral Investing.” In 2000, the average target price of stocks was 37% above market price and they ended up 16%. In 2008, the average forecast was a 28% increase and the market fell 40%. Between 2000 and 2008, analysts failed to even get the direction right in four out of the nine years.
Finally, Michael Sandretto of Harvard and Sudhir Milkrishnamurthi of MIT looked at the one-year forecasts of 1000 companies covered most widely by analysts. They found that analysts were consistently inconsistent, missing the market by an annual rate of 31.3% on average.”
So, I want to ask you again, do you think earnings are the proper way to prognosticate the market or your investing in specific stocks?
The truth is that earnings will be rising while the market is rising. And, during the heart of a bull market, the direction of earnings will clearly coincide with the direction of the stock market or the individual stock at issue. This is why they say that bull markets make everyone look like a genius.
However, when the market and/or the stock is topping out, it will take some time before you see that in the earnings of the company. And, when you finally come to this realization about earnings, you will recognize that following earnings will likely lead you to always being caught looking the wrong way when it counts – at the major market turns. Until then, you will likely believe yourself to be a genius, until you get caught at the next highs.
Good luck investing based upon earnings.
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