introduction
What drives stock returns? Earnings, right? So what drives earnings? Probably economic growth. After all, it’s much harder for corporations to grow their revenues and profits in a sputtering economy.
However, the connection between stock returns and economic growth is more illusion than reality. It could seem logical, but there’s little actual data to support it.
For example, China’s economy has grown at a reasonably consistent and impressive pace since 1990, about 10% per yr.This must have provided ideal conditions for Chinese equities to rally and generate attractive returns. But investing in Chinese equities has not been so smooth. The Shanghai Composite Index has been up since 1990, but its performance has been anything but consistent, with several declines of fifty%.
There is an easy explanation for this lack of correlation: In the past, the Chinese stock market was dominated by largely unprofitable state-owned enterprises and didn’t reflect the otherwise very dynamic economy.
But China is hardly an outlier. Elroy Dimson, Jay R. Ritter and other researchers have shown that the connection between economic growth and stock returns has been weak, if not negative, almost in all places. They examined developed and emerging markets throughout the twentieth century and provided evidence that’s difficult to refute.
Their results suggest that the connection between economic developments and movements within the stock markets, so often made by stock market analysts, fund managers and the financial media, is essentially false.
But what about earnings, which determine stock returns? Does this connection still hold? After all, basic finance teaches us that an organization’s valuation reflects its discounted future money flows. So let’s have a look at if we are able to at the least confirm this connection.
Profits vs. Stock Returns
To examine the connection between US equity market returns and earnings growth, we first calculated the rolling five-year returns of each time series using data from Robert J. Shiller at Yale University They return greater than a century. From 1904 to 2020, earnings growth and stock returns moved in lockstep during certain periods, but there have been many years once they diverged completely, as shown by a low correlation of 0.2.
The perspective doesn’t change if we modify the rolling return window to at least one or ten years, or if we use real slightly than nominal stock prices and earnings. The correlation between US stock market returns and earnings growth has been virtually zero over the past century.
US stock returns and earnings: rolling returns over the past five years
Profit growth was estimated at 350%.
Perhaps the dearth of correlation between stock returns and earnings growth is because investors concentrate on expected growth slightly than current growth. After all, the valuation of an organization is predicated on discounting future money flows.
We tested this hypothesis by specializing in earnings growth over the following 12 months and assuming that investors can perfectly forecast earnings for U.S. stocks. We treat them as superinvestors.
But knowing the earnings growth rate prematurely wouldn’t have helped these superinvestors time the stock market right. Only within the worst decile of future earnings growth percentiles were returns negative. Otherwise, whether the earnings growth rate was positive or negative had little impact on stock returns.
US Stock Returns: Next 12-Month Earnings Growth vs. Equity Returns, 1900-2020
Earnings growth was estimated at 100%.
Earnings growth vs. P/E ratio
We can extend this evaluation by examining the connection between earnings growth and P/E ratios. Rationally, there needs to be a powerful positive correlation, as investors reward high-growth stocks with high multiples and punish low-growth stocks with low ones. Growth investors have repeated this mantra to clarify the acute valuations of technology stocks like Amazon or Netflix.
Again, the information doesn’t support such a relationship. The average P/E was indifferent to the expected earnings growth rate over the following 12 months. In fact, higher future growth led to P/E multiples that were barely below average.
If the main focus were on current earnings, our explanation could be that a rise in earnings robotically results in a discount within the P/E ratio. However, for future earnings, these results are less intuitive.
US equity returns: 12-month earnings growth versus P/E ratios, 1900–2020
Earnings growth was estimated at 100%.
Further considerations
Why are profits so unimportant for stock market returns?
The easy explanation is that investors are irrational and stock markets are usually not perfect discounting machines. Animal spirits are only as vital, if no more vital, than fundamentals. The tech bubble of the late Nineties and early 2000s is a superb example of this. Many successful corporations of that point, equivalent to Pets.com or Webvan, had negative earnings but rising share prices.
Does this mean that investors should ignore profits altogether?
Many are already doing so. Millennials specifically have made big bets on GameStop, for instance, and a few hedge fund managers are pursuing momentum strategies. And while the previous hardly looks as if a solid investment, the latter is a wonderfully acceptable strategy that does not require earnings data.
While earnings mustn’t be completely ignored, investors mustn’t assume that they’re the actual driver of stock returns.
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Photo credit: ©Getty Images / Andrew Holt
