Earnings versus Market Movements

Over the long term, the biggest factor in market returns is earnings growth. In the short-term, returns are not dictated by earnings but rather the psychology of market participants. These range from overly confident to overly pessimistic, with infrequent spells of equilibrium, or consensus.

Ultimately, however, company earnings drive stock market returns. Historical research has shown that these two variables track each other over the longer term, but not exactly. However, it is through bouts of over confidence and pessimism that savvy investors can prosper. It therefore makes sense that investor returns will be dictated almost exclusively by the growth in company earnings and the initial price paid on those earnings.

Earnings and dividends are far more stable than day-to-day stock market movements as a result of investor moods. Research has shown that investors usually overreact to news (and expected news). As markets are forward looking (a fact that is all too often lost on the part-time investor), news has the effect of making investors over-react, either on the upside or the downside. Often, stock prices move too high with an expected increase in earnings, and too low with an expected decrease in earnings.

Strangely enough the market tends to fall by more after a negative earnings outlook than it does for a similar earnings increase. Significant increases in earnings often pale into comparison to significant earnings decreases and the resultant effect on stock prices. In terms of behavioral finance, it’s a fairly well-known concept that investors suffer 2.5 times more for a loss than they do for the same percentage gain.

Markets are also forward looking which means prices fall in anticipation of earnings. If a bad economic outlook and hence earnings are forecast, stock prices usually fall before such an event becomes a reality. The lag between price movements and actual earnings results varies to a large degree, but has typically been around one year. Another interesting aspect is that large market corrections don’t always occur on the expectation of a drop in earnings. The crashes in 1987 and 1998 are two specific examples of how prices failed to anticipate certain scenarios.

Markets around the world have moved into rather expensive territory after the large rally experienced since March last year. While short-term market movements are by their nature unpredictable, it’s my opinion that the patient and conservative long-term investor should sit on the sidelines at the moment until low valuations present themselves. I am not advocating timing markets, but rather the patience necessary to wait for good opportunities in terms of price and valuation to emerge.