Another corporate earnings season is upon us, and analysts are again talking about the impact of earnings on the broad stock market.
Yet, with so much emphasis on earnings, this next part may come as a shock: The idea of earnings driving the broad stock market higher or lower is a GIANT myth.
When you make a claim like that, you better have proof. And we do. Below are a couple of “exhibits” from Elliott Wave International’s research portfolio that shed light on this persistent myth.
“Exhibit 1”: Excerpted from Robert Prechter’s February 2010 Elliott Wave Theorist
This belief powers the bulk of the research on Wall Street. Countless analysts try to forecast corporate earnings so they can forecast stock prices. The [news-driven] basis for this research is quite clear:
Corporate earnings are the basis of the growth and the contraction of companies and dividends. Rising earnings indicate growing companies and imply rising dividends, and falling earnings suggest the opposite. Corporate growth rates and changes in dividend payout are the reasons investors buy and sell stocks.
Therefore, if you can forecast earnings, you can forecast stock prices.
Suppose you were to be guaranteed that corporate earnings would rise strongly for the next six quarters straight. Reports of such improvement would constitute one powerful “information flow.” So, should you buy stocks?
Figure 9 shows that in 1973-1974, earnings per share for S&P 500 companies soared for six quarters in a row, during which time the S&P suffered its largest decline since 1937-1942.
This is not a small departure from the expected relationship; it is a history-making departure. Earnings soared, and stocks had their largest collapse for the entire period from 1938 through 2007, a 70-year span! Moreover, the S&P bottomed in early October 1974, and earnings per share then turned down for twelve straight months, just as the S&P turned up!
An investor with foreknowledge of these earnings trends would have made two perfectly incorrect decisions, buying near the top of the market and selling at the bottom.
In real life, no one knows what earnings will do, so no one would have made such bad decisions on the basis of foreknowledge. Unfortunately, the basis that investors did use — and which is still popular today — is worse:
They buy and sell based on estimated earnings, which incorporate analysts’ emotional biases, which are usually wrongly timed.
But that is a story we will tell later. Suffice it for now to say that this glaring exception to the idea of a causal relationship between corporate earnings and stock prices challenges bedrock theory.
“Exhibit 2”: The behavior of stocks vs. earnings during the 2007-2009 financial crisis
But look, that was in the 1970s. Who cares — that’s ancient history, right? Things are different now.
Take a look at this excerpt from EWI’s March 2009 Elliott Wave Financial Forecast:
You can see that 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: In 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.
Puzzling? You can say that again. But looking at “fundamentals” like earnings to forecast the broad market will get you puzzled again and again. “Simple logic based on external causes does not work in predicting financial markets,” as Bob Prechter puts it.
“Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again.
“But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices.
“Investors who [buy] stocks based on strong earnings (and the trend of higher earnings) [get] killed.”
For more investment insights like these, please visit elliottwave.com.
Until Next Time,
Vadim Pokhlebkin, Elliott Wave International
Elliott Wave International is the world’s largest independent market forecasting firm covering every major market (stocks, FX, bonds, energy, metals, commodities) worldwide, 24 hours a day at ElliottWave.com and proprietary web systems like Bloomberg. EWI’s subscriber base includes major banks, hedge and pension funds, insurance companies, as well as tens of thousands of individual investors. EWI’s free online Club EWI community has over 350,000 members.