Digging Deeper: Do Strong Company Earnings Translate Into Strong Investor Returns?

Jul 23, 2018
Investing, Stocks, Index Funds

“Earnings Are Booming. Stocks Not So Much.” So reads the title of a New York Times DealBook article on July 20. For those who have heard the mantra that "company earnings drive the stock market," this headline perplexes. This title resonated with me, probably because I have been reading The Little Book of Common Sense Investing by John Bogle for this month’s FinLit Fanatics book club.   Let’s outline some of the lessons from the book and then see how the might explain the current situation where company earnings are surging and stock prices are not following. 

The book’s key message is understanding the “relentless rules of humble arithmetic,” which, in turn, explain why you should a) focus on the lowest cost index funds to b) replicate the total market in your portfolio. However, the book goes much deeper than that, which is why I found this article interesting.

Early on in the book, Chapter 2 in fact, Bogle presents some historical data on total stock returns between 1900 and 2016 (Exhibit 2.2 in the newest edition). He shows the composition of the total market (S&P 500) average annual return by decade and dissects stock market returns into it's three components:

  • The “Investment” return--the sum of the dividend yield plus...
  • Earnings growth is added to the...
  • Speculative” return, which represents the average annual impact of the change in the P/E (Price/Earnings) ratio.

Add these three factors together and voila, you get the average stock market returns. 

As the chart above from the 2007 edition shows, the investment return has been fairly stable over the decades, with the exception of the decades of the Great Depression and Great Recession. The speculative return, on the other hand, swings between positive and negative almost every decade. The key exception would be the positive returns for both the 80’s and 90’s. The 2000's ended up with a 0.6% investment return, a -3.0% speculative return and a net -1.3% market return.  For the 2010’s through 2016, these returns are 11.2%, 1.4% and 12.7%, respectively.  (If you are following this reasoning and this historical pattern, we should be preparing for a negative speculative return in the next decade…..just saying.)

So let’s get back to the article. It was mentioned that over the last five years, over 70% of the companies reporting earnings every quarter beat the analysts projected earnings. So far, for the second quarter of this year, 87% of those reporting have exceeded expectations. Earning are up on average over 20% from the prior year. Based on the historical data in Bogle’s book, one might expect this to pass through to the total market return, yet the market is only up 4.9% for the year, having fallen back from the year’s high in January. So we must look to the speculative component of the total return for answers.

We first look at projected P/E ratios.

The forward price-to-earnings ratio of the S. & P. 500 stands at 16.5, slightly above the 10-year average of 14.4. That valuation takes into account profits rising nearly 20.6 percent this year, the best annual growth rate since 2010.

In other words, expectations for strong earnings growth have already been reflected in the stock prices, driving the P/E ratio up above the ten-year average. Recent positive earnings reports therefore have no additional impact on stock prices.

Other factors include the fact that much of recent corporate earnings jump can be attributed to the change in the tax law and will not be replicated. The final factor holding stock prices back is the uncertainty surrounding the impact of tariffs and the mounting trade war. Impacts are just beginning to be felt. For example, the WSJ had a front-page article today on the impacts it is having on the meat industry alone. Stockpiles of meat reached 2.5 billion pounds as production has been increasing as exports have dropped precipitously.

Finally, what we cannot measure or predict is another key component to market movements mentioned by Bogle—emotions. The NYT article concludes:

…the relationship between earnings and stock market performance is sometimes not cut and dried. Bank of America Merrill Lynch looked at 90 years of stock market data and found that the S. & P. 500 was slightly more likely to finish a year lower when earnings growth topped 10 percent than when it failed to reach double digits.

What to do? Keep the long-term view and don’t worry about it. Keep buying your low-cost index funds and hang on. Know that you might want to save more to account for the fact that you may not have the wind at your back as speculative returns in the future may disappoint. 

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an M.B.A. in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducting student workshops, and developing finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.