One of the most common perspectives that I have seen in the market through my investing career is the old adage that is often repeated by Larry Kudlow:
“Earnings are the mother’s milk of stock prices.”
What Larry is saying, and what has been universally adopted by the masses, is that earnings are what drive stock prices. And, this week, we're going to enquire as to the absolute truth of this commonly held belief.
However, I must warn you. If you're absolutely convinced of this premise (as are many) and will never be swayed by empirical evidence that could demolish your currently held perspective, then you may want to stop reading right here. Also, this is a bit of a long article, so make sure you have some time to read through it, as it contains a lot of information.
We all know that it's “common knowledge” that earnings are what drive stock prices. I mean, everyone knows this as an absolute stock market fact. Yet, consider that several centuries ago everyone also knew that the earth was flat. Let’s try to consider how the stock market world is round rather than flat.
How often do you see earnings announced for a stock, and the stock does the exact opposite of what you would expect? We have all seen it happen. And, if you're being honest with yourself, then you would remember many a time where you were sitting at your desk, watching the stock price and scratching your head.
And, what do the talking heads parrot in unison when this occurs? “The information was already priced in.” Yes, my friends, this is known as the “priced-in-premise.”
In fact, when they announce the “priced-in-premise” after a stock tanks on good earnings, each and every person listening to or reading these talking heads simply nods in sheepish acceptance.
But, have any of you actually considered what this really means?
If you believe that blow-out earnings were already priced in when a stock declines after those earnings are announced, then you must believe that the market is omniscient. It means that the market knew what the earnings would be before they were announced and pushed the stock price up with the expectation of blow-out earnings. (By the way, I thought they called this “insider trading” – but that is a whole other matter.)
So, the logical question then is why were the analysts so surprised by a stock declining if the good earnings were already “priced in” and already expected by the market? Do the analysts not understand the market?
Are you seeing the circular reasoning this “priced in” perspective is based upon?
Well, I don’t know about you, but I think the “priced-in premise” is based upon horse manure. I do not believe investors are omniscient. The “priced-in premise” is another way for the analysts to say we have no clue why the market declined on good earnings news. Otherwise, if investors really knew the information beforehand in order to push the stock price up in anticipation of these earnings, then we would not have a prohibition against insider trading.
But, if you want to hear the truth about earnings, I want to present to you a quote from a client that is a CFO of a large publicly-traded company. In fact, this comment mirrors many similar comments I hear from CEO’s and CFO’s of large corporations that are clients of mine:
“Having worked for many listed companies and regarded as an insider with access to company confidential information, I have sometimes struggled to understand the correlation between business results and the share price.”
If this anecdotal evidence is not swaying you (and I don’t necessarily blame you), let’s review some of the studies that have been conducted on this topic.
In a 1988 study conducted by Cutler, Poterba, and Summers entitled “What Moves Stock Prices,” they reviewed stock market price action after major economic or other type of news (including major political events) in order to develop a model through which one would be able to predict market moves retrospectively. Yes, you heard me right. They were not even at the stage yet of developing a prospective prediction model.
However, the study concluded that “macroeconomic news bearing on fundamental values explains only about one fifth of the movement in stock market prices.” In fact, they even noted that “many of the largest market movements in recent years have occurred on days when there were no major news events.” They also concluded that “there is surprisingly small effect (from) big news (of) political developments... and international events.”
In August 1998, the Atlanta Journal-Constitution published an article by Tom Walker who conducted his own study of 42 years’ worth of “surprise” news events and the stock market’s corresponding reactions. His conclusion, which will be surprising to most, was that it was exceptionally difficult to identify a connection between market trading and dramatic surprise news.
Based upon Walker's study and conclusions, even if you had the news beforehand, you would still not be able to determine the direction of the market only based upon such news.
In 2008, another study was conducted with regard to specific stocks in which they reviewed more than 90,000 news items relevant to hundreds of stocks (including earnings) over a two-year period. They concluded that large movements in the stocks were not linked to any news items:
“Most such jumps weren’t directly associated with any news at all, and most news items didn’t cause any jumps.”
Now, if you want some real-world specific data, I want to start with an article by Lance Roberts published at the end of 2017.
Technically Speaking: This Is Nuts
Within this article, Lance cited a Doug Kass note discussing the disparity between stock prices and earnings, in which he stated:
“Despite many who are suggesting this has been a 'rational rise' due to strong earnings growth, that is simply not the case as shown below . . . Since 2014, the stock market has risen (capital appreciation only) by 35% while reported earnings growth has risen by a whopping 2%. A 2% growth in earnings over the last 3-years hardly justifies a 33% premium over earnings.
Of course, even reported earnings is somewhat misleading due to the heavy use of share repurchases to artificially inflate reported earnings on a per share basis. However, corporate profits after tax give us a better idea of what profits actually were since that is the amount left over after those taxes were paid.
Again we see the same picture of a 32% premium over a 3% cumulative growth in corporate profits after tax. There is little justification to be found to support the idea that earnings growth is the main driver behind asset prices currently.
We can also use the data above to construct a valuation measure of price divided by corporate profits after tax. As with all valuation measures we have discussed as of late, and forward return expectations from such levels, the P/CPATAX ratio just hit the second highest level in history."
So, what is Lance’s conclusion from the Kass note?
“The reality, of course, is that investors are simply chasing asset prices higher as exuberance overtakes logic.”
And, all of this leaves me scratching my head.
First, Kass almost came to a logical conclusion when he noted that “there is little justification to be found to support the idea that earnings growth is the main driver behind asset prices currently.”
But he missed the boat when he added that last word “currently.” He would have been 100% accurate if he had simply noted his conclusion without that last word. If earnings are only lining up with market direction part of the time, then it's clear that earnings are only a coincidental factor (rather than the driving factor) during other times when they are seemingly driving price.
You see, if something does not drive the market all the time, how can you assume it is really a causative factor rather than a coincidental factor during the minority of the time it is in alignment with a market move? Even if it aligns 60% of the time, it's still a coincidental factor rather than a causative factor. To state otherwise is simply not accurate. I mean, either the steering wheel directs the car all the time or it does not. I will again address this later on in the article.
Now, let’s deal with Lance’s conclusion. Lance’s conclusion presupposes that “logic” is what normally drives the market. So, if exuberance is taking over logic, clearly he views logic as the primary and predominant force driving the market the majority of the time. Now, let me ask you this: When was the last time you sought out the services of a logician to determine the market’s next move?
And, I'm quite sure I know your answer to the question I just posed. Now, do you know why you don’t seek out the services of a logician to determine the market’s next move? Yup. You guessed it. Because logicians would never be able to provide you with consistent correct responses because markets are not driven by logic. Rather, the market is driven by investor sentiment ALL the time (i.e. emotion), as compared to the erroneous belief that it is being driven by some coincidental factor, such as earnings, some of the time.
I use this example quite often. If you're attempting to impose logic in an emotional environment, it's akin to you attempting to argue logic to your spouse when they are emotional. How well does that work for you?
Let’s now move to further empirical research conducted by Robert Prechter in the following article: The Myth of Company Earnings and Stock Price.
Bob cites The Wall Street Journal article which 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.”
Feel free to read that again. The empirical evidence noted by the Wall Street Journal article blows a hole through the premise that earnings drive stock prices. Someone please inform Larry Kudlow before I have to again hear him uttering that old, tired and wrong proposition.
Furthermore, our friends at Elliott Wave International provided us with research which should put a nail in the coffin of the earnings-driving-stock-prices premise, as they proves to us that the world is actually round:
“Since 1932, corporate profits have been down in 19 years. Did stocks fall? No: The Dow rose in 14 of those years. Conversely, in 1973-74, earnings rose 47% -- yet, the Dow fell 46%. In fact, 12-month earnings peaked at the bear market low.
But who cares about the 1930s and '70. That's ancient history, right? Things are different now. OK, then how about the very recent history: The financial crisis and Great Recession, when the stock market peaked and crashed (in 2007-2008) and bottomed (in 2009)? . . . earnings were at their highest level in June 2007. Stocks were at record highs, too. The mainstream "vision" of how earnings affect stock prices demands that strong earnings should have propelled stocks even higher. Yet, the exact opposite happened: It 2007, earnings were the strongest right before the stock market's historic top.
Then, after stocks had crashed, earnings turned negative in December 2008 (actually negative, for the first time since 1935!). That should have pushed stocks even lower. Yet, the exact opposite happened: Stocks began a huge rally shortly after earnings turned negative.”
As Bob appropriately noted:
“what shapes stock market trends is how investors collectively feel about the future. Investors' mood—or social mood—changes before "the fundamentals" reflect that change, which is why trying to predict the markets by following the earnings reports and other "fundamentals" will often leave you puzzled.”
Let me give you what I think is an outstanding example of the point I am trying to make. Let’s discuss the spring of 2020.
If you remember, the market bottomed on March 23, and just as we were bottoming and beginning on of the strongest rallies in history, we began seeing high death rates, record unemployment, and economic shutdowns. Certainly, this was not a time in which many were looking to the future for higher earnings. The mood in the business world was quite bleak, and we were only hearing reports of how it was going to get worse all around. In fact, economists continued to declare us in being in recession even though the market rallied 50% and over 1000 points off the March lows.
Yet, as we know, the market bottomed on March 23 during this bleak period and began one of the strongest rallies in stock market history. This market action defied almost all logic and expectation.
At the time, I advised my clients to begin buying the market again as we were approaching my downside target of 2200SPX, wherein I expected to see a climax in bearishness and the potential we would begin a new rally pointing us to 4000-plus.
In fact, at the time I was publishing my perspective, I received the following comment:
“Coming from someone who still thinks the bull market of January is alive enough to carry us to 4,000, that's highly unmeaningful... Here is the 2200 exactly that you said the S&P would bottom at before taking the trip back up to 4,000... What do you want to bet the ECONOMY is going to pull it down a lot further and that 4,000 is a lot further away than your charts ever said... THIS bull market did not ever come close to taking us to 4,000, and it is not taking us anywhere ever again because it is DEAD. OFFICIALLY and in EVERY way. Every index is DEEPLY into a bear market now. The bull is dead, and so it can NEVER take us to 4000. What you predicted can NEVER come true now... my own resolution is that this market has a lot further to fall because it is now following the economy, which it long divorced itself from; whereas Avi doesn't believe the economy ever means anything to stocks and has told me so several times last year... So, you have that common sense view, or you can believe Avi's chart magic will get you through all of that and is right about a big bounce off of 2200 all the way back up to 4,000.”
But, you see, how could anyone have looked at the market any other way unless you really understood that the market is driven by psychology? Can anyone truly or honestly claim that it was earnings that caused the rally we experienced off the March 2020 low? Well, not if you are living in reality.
So, please allow me to explain why the market turned well before anyone saw it was even possible, especially in light of all the extremely negative news.
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's 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.
As Alan Greenspan once noted:
“It's only when the markets are perceived to have exhausted themselves on the downside that they turn.”
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're 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 earnings 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.
Let's look at the same change in positive sentiment and what it takes to have an effect on the earnings and 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're 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's a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying earnings of a stock or fundamentals of 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 and earnings are lagging indicators 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's also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns.
Finance professor Robert Olson published an article in 1996 in the Financial Analysts Journal in which he presented the conclusions of his study of 4000 corporate earnings estimates by company analysts:
“Experts’ earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation. This article suggests that the human desire for consensus leads to herding behavior among earnings forecasters.”
Yet, people still claim that earnings and earnings expectations are what drive the stock market?
By the time earnings are affected by a positive change in social mood, the social mood trend has already been positive 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, as I noted before, economists declared us to be in recession even though the market was 50% and over 1000 points off the lows.
Clearly, earnings estimates and expectations when the market bottomed in March of 2020 were quite bleak. And, as you may be able to surmise, you're 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.
Let’s go further and consider what Daniel Crosby highlighted about earnings in his book The Behavioral Investor:
“Contrarian 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 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. And, it's also why I claim that earnings are only a coincidental factor during market trends rather than a driving factor.
However, when the market and/or the stock is topping out or bottoming out, it will take some time before you see that in the earnings or the earnings estimates 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 or lows.
So, I apologize for my pushing you to think beyond your black and white perceptions about the stock market. But before I conclude this article, allow me to provide a bit of illumination as to how your mind works so you can understand why you maintain these false beliefs about the market.
Let’s start with the perspective of Nobel Award winning psychologist Daniel Kahneman.
Kahneman outlines that we have a puzzling limitation within our minds which is due to an “excessive confidence in what we believe we know, and our apparent inability to acknowledge the full extent of our ignorance and uncertainty of the world we live in. We are prone to overestimate how much we understand about the world . . overconfidence is fed by the illusory certainty of hindsight.”
As Arnold Wood, President and CEO of Martingale Asset Management noted:
“People tend to repeat the same errors in judgement day in and day out, and not only do they do it with predictability, they do it with confidence.”
As Amos Tversky, who worked extensively with Kahneman, once noted:
“Study after study indicates, however, that people judgments are often erroneous – and in a very predictable way. People are generally overconfident. They acquire too much confidence from the information that is available to them, and they think they are right much more often than they actually are.”
And, as Wener F.N. De Bondt, Frank Garner Professor of Investment Management at University of Wisconsin-Madison noted:
“People have an enormous capacity to rationalize facts and fit them into a pre-existing belief system.”
As Ben Franklin appropriately noted many years ago:
”So convenient a thing it is to be a reasonable creature, since it enables one to find or to make a reason for everything one has a mind to do.”
What makes this worse is that our minds engage in an automatic search for causality for our erroneous beliefs. According to Kahneman, there is evidence that we are born prepared to make intentional attributions within what he called “positive test strategy.”
“Contrary to the rules of philosophers of science, who advise testing hypotheses by trying to refute them, people seek data that are likely to be compatible with the beliefs they currently hold. The confirmatory bias (of our minds) favors uncritical acceptance of suggestions and exaggerations of the likelihood of extreme and improbable events... (our minds are) not prone to doubt. It suppresses ambiguity and spontaneously constructs stories that are as coherent as possible.”
As Daniel Crosby, the author of The Behavioral Investor noted:
“trusting in common myths is what makes you human. But learning not to is what will make you a successful investor.”
Lastly, as Isaac Asimov noted:
“Your assumptions are your windows on the world. Scrub them off every once in a while, or the light won't come in.”
If you recognize that the world is round, maybe it’s time to scrub your assumptions about earnings so you can become a better investor?
Just a thought . . a very long thought. (smile)