STAY FOCUSED ON EARNINGS

J. Andrew Concannon

J. Andrew
Concannon, CFA

Chief Investment Officer

7-1-16 -

"Earnings are the most important factors in determining the direction of stock prices."

The chart below shows both the monthly prices and forward 12-months earnings for the S&P 500 Index since January 2000. What the chart makes clear is the stock prices and earnings move together. In fact, the two have a correlation of +0.8, which is quite significant considering that the measurement for correlation range from +1.0 when two items move perfectly together to -1.0 when two items move exacly opposite of one another.

The fact that stock prices move so closely with earnings should be of no surprise. After all, the primary reason to invest in a company's stock is to own of a portion of that company's earnings. As simple as that seems, it cannot be overstated. And it is the reason that over time earnings are the most important factors in determining the direction of stock prices.

So Many Distractions

Investors sometimes lose focus on the importance of earnings and get caught up watching other things. We are often asked for our thoughts on how current news, upcoming events, or valuations will affect the direction of stock prices. These and other items can combine to make stock prices more volatile than earnings. But longer term, it is the direction of earnings that leads the way for stock prices.

Note that in the chart, stock prices move up and down in the short term much more than earnings. This excess volatility is often explained by news items. Many investors understandably would like to know how the news will affect the prices of their stocks. But news items are of little help in predicting stock prices because the news cannot be known in advance. Otherwise, it wouldn’t be news.

Once a news item is known, the focus for stock investors should be on how it affects corporate earnings. Many times, however, investors will over or under estimate the true impact of news. A slowdown in China’s rate of economic growth, for example, was recently credited for stock market declines. China has been the largest contributor to worldwide economic growth for more than a decade, so it seems reasonable that a slowdown could negatively affect the earnings of U.S. companies. But if you look at the data you find that sales to China represent a relatively small portion of the overall U.S. economy. According to the U.S. Census Bureau, exports of U.S. goods to China represent just 0.7% of all U.S. goods.1 Thus, the impact on overall U.S. corporate earnings resulting from a slowdown in the Chinese economy is limited.

The U.S. presidential election is an upcoming event that is currently getting a lot of attention. Investor concerns seem to mimic those of voters in general—the majority of whom rate both major parties’ presumptive candidates unfavorably. In fact, in a recent Washington Post/ABC News poll the two candidates’ unfavorable ratings ranked first and second dating back to 1984.2

It is no surprise that having two unpopular presidential candidates is a cause of investor concern. But purely from a stock investing standpoint, investors should focus on what effect the two candidates’ agendas might have on corporate earnings. And further, what are the odds that Congress, knowing of the candidates’ unfavorable ratings, will feel compelled to participate in any part of those agendas?

In addition to news and upcoming events, investors often focus on valuation in an attempt to predict future stock prices. And while valuation is certainly an important factor in investing, its influence on stock prices tends to be with the degree of changes, not the direction. As shown on the chart, when stock valuations were high in 2000, the relatively modest decline in corporate earnings that followed caused an oversized decline in stock prices. Conversely, after stock valuations became depressed in 2009, prices rose more than earnings during the recovery that followed. Yet, in both cases it was a change in the direction of earnings that determined the direction of stock prices.

Recent Trends in Earnings

Over the past 13 months stock prices, as measured by the S&P 500® Index, have experienced a lot of volatility but no progress. Turning to our chart, we see that corporate earnings failed to grow during this period. So once again, it was earnings that determined the trend in stock prices.

The two primary factors restraining overall corporate earnings growth of late have been the sharp declines in commodity prices, particularly oil, and the rise in the value of the U.S. dollar. These moves began in 2014 and generally continued until February of this year. Since February, however, commodity prices have risen and the dollar has declined. Should the two hold at current levels or continue their recent trends, it will be favorable for U.S. corporate earnings as a whole.

It is the effect on earnings of items like these that should be your focus as a stock investor. So the next time a news story or upcoming event causes you to worry about your stock portfolio, ask how it will affect earnings.

1 According to the U.S. Census Bureau, exports of U.S. goods to China represent just 0.7% of all U.S. goods.

2 In fact, in a recent Washington Post/ABC News poll the two candidates’ unfavorable ratings ranked first and second dating back to 1984

The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.