What drives stock returns? Earnings, right? So what generates revenue? Likely economic growth. After all, it’s much harder for businesses to increase sales and profits in a sluggish economy.
However, the relationship between stock returns and economic growth is more illusion than reality. It may sound logical, but there’s little real data to back it up.
For example, China’s economy has grown at a fairly steady and impressive rate of about 10% per year since 1990. This should have provided ideal conditions for Chinese equities to thrive and generate attractive returns. But investing in Chinese stocks has not been so simple. The Shanghai Composite Index has been rising since 1990, but the trajectory has been anything but constant, with multiple declines of 50%.
This lack of correlation has a simple explanation. The Chinese stock market has historically been dominated by largely unprofitable state-owned enterprises (SEs) and has failed to reflect the otherwise buoyant economy.
But China is no exception. Elroy Dimson, Jay R. Ritter, and other researchers have shown that the relationship between economic growth and stock market returns is weak or even negative almost everywhere. They have studied developed and emerging markets throughout the 20th century and provide evidence that is hard to refute.
Their findings suggest that the link so often drawn between economic developments and stock market movements by stock analysts, fund managers and the financial media is largely misguided.
But what about earnings that boost stock returns? Is this relationship still true? After all, Finance 101 teaches that a company’s valuation represents its discounted future cash flows. So let’s see if we can at least validate this connection.
Earnings vs stock returns
To explore the relationship between US stock market returns and earnings growth, we first calculated the five-year rolling returns of the two time series using data from Robert J. Shiller at Yale University dating back more than a century. From 1904 to 2020, earnings growth and stock returns moved in tandem over some periods, however, there were decades when they diverged completely, as shown by a low correlation of 0.2.
The outlook does not change if we switch the rolling yield calculation window to one or 10 years, or if we use real rather than nominal prices and earnings. The correlation between US stock returns and earnings growth was virtually zero over the past century.
US Equity Returns and Earnings: Five-Year Rolling Returns
The lack of correlation between stock returns and earnings growth may be due to investors focusing on expected growth rather than current growth. After all, the valuation of a business is based on discounting future cash flows.
We tested this hypothesis by focusing on earnings growth for the next 12 months and assuming that investors are perfect forecasters of US equity earnings. We treat them like super-investors.
But knowing the earnings growth rate ahead of time wouldn’t have helped these super-investors time the stock market. Returns were negative only in the worst decile of forward earnings growth percentiles. Otherwise, whether the earnings growth rate was positive or negative had little impact on stock returns.
U.S. Equity Returns: Next 12-Month Earnings Growth Versus Equity Returns, 1900–2020
Earnings growth vs. P/E ratios
We can extend this analysis by looking at the relationship between earnings growth and P/E ratios. On a rational level, there should be a strong positive correlation as investors reward high growth stocks with high multiples and penalize low growth stocks with low multiples. Growth investors have repeated this mantra to explain the extreme valuations of tech stocks like Amazon or Netflix.
Again, the data does not support such a relationship. The average P/E ratio was indifferent to the expected earnings growth rate over the next 12 months. Indeed, the higher forward growth translated into slightly below-average P/E multiples.
If the focus were on current earnings, our explanation might be that an increase in earnings leads to an automatic reduction in the P/E ratio. But with the term benefits, these results are less intuitive.
US Equity Returns: Next 12-Month Earnings Growth vs. P/E Ratios, 1900–2020
Why do earnings matter so little to stock returns?
The simple explanation is that investors are irrational and stock markets are not perfect discounting machines. Animal spirits matter as much if not more than the fundamentals. The tech bubble of the late 1990s and early 2000s is a prime example. Many high-flying companies of this era like Pets.com or Webvan had negative earnings but skyrocketing stock prices.
Does this mean investors should completely ignore earnings?
Many already do. Millennials, in particular, have made big bets at GameStop, for example, and some hedge fund managers are pursuing dynamic strategies. And while the former hardly seems like a wise investment, the latter is a perfectly acceptable strategy that requires no earnings data.
So while earnings shouldn’t be ignored entirely, investors shouldn’t assume they’re driving stock returns either.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images / Andrew Holt
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