You guys know that I am a pure Technical Analyst. Yet, today I am going to throw a bit of fundamentals into the mix. I’ll be talking about the relationship between earnings and stock market performance.
2023 was an unusual year, insofar as earnings vs. stock market performance was concerned. Investors drove stock prices higher without improving fundamentals (earnings). Lets look at the relationship between earnings and stock market returns over the past 15 years (since the 2009 crash). Can we predict market returns by earnings growth?
To start, the rise in a stock (or index) can be due to three factors:
1) An increase in earnings per share
2) An increase in the valuation investors place on those earnings
I’m going to start off by comparing earnings trends to market performance trends. Dividends are almost never the primary driver of price.
SPX vs earnings (trailing)
Below is a chart of the SPX earnings (black line) vs the SPX index (red line). From left to right, note my arrows:
- Flat earnings (no/low growth environment) don’t always mean a declining stock market. But they can mean an initially less enthusiastic market before it rises. Check out 2011/12 (left side of chart) as an example.
- Declining earnings, like in 2015 (a result of the low growth economy in 2013) resulted in a declining market. That was corrected to the upside for the SPX in 2016 while earnings were flat. Declining earnings also occurred during rapid market declines like the sub-prime 2009 crash (not shown) and the COVID crash of 2020 (seen below). Declining earnings were also coincidental with a declining market in 2022.
- Flat/ slightly rising earnings were seen in 2023. Meanwhile, the SPX took off like a bat outta hell (credit to Meatloaf). That’s what I’m here to discuss today.
The big question: If earnings continue to be flat—will markets decline?
Last year was driven by an increase in multiples, not fundamentals
Almost all of the S&P 500’s returns last year were due to an increase in the valuation (PE). Very little of it was driven by an increase in actual earnings – as the rather tame looking earnings (black line, above) illustrates. This happens often enough – history shows us that the SPX foresees future earnings strength and can rise prior to that happening. Check out 2012, and 2020 above.
However….what happens if – after the the index’s rise due to an expansion in valuations – earnings don’t follow through?
The chart below – courtesy sentimentrader.com, shows us PE ratio (orange), Earnings (blue) and dividends (grey) in their contribution to returns on the SPX.
The above chart, courtesy of sentimentrader.com, illustrates how much of the gain in the SPX was due to an increase in the multiple in 2023. This situation is much like 2012/13. If you look at my top chart, you’ll note the rising SPX with flat earnings during that period. However, you’ll also note that by mid 2013 earnings began to rise aggressively. The rising SPX during 2012 was justified – the market was looking forward. It correctly foresaw rising earnings.
This happened in 2020, too. the SPX fell with earnings at first, then began to rise aggressively – looking forward, correctly foreseeing rising earnings ahead.
In 2023, the SPX was foreseeing rising earnings ahead – witnessed by its strong performance. The SPX has been accurate in the past by rising ahead of earnings growth, seen in the above charts.
However…. If earnings don’t follow through, and companies earn less than expected, stocks could be very vulnerable to a correction. The SPX’s rise in 2023 was predicting a renewal in earnings growth coming.
The beauty of Technical Analysis.
At the end of the day, we need only pay attention to price. Its no sense trying to figure out if the market has it all wrong this time/ if earnings growth will not return. Instead, we should follow our rules and trade accordingly. For those who have not taken my Online Trading Course, now might be a good time to do so. Conversely, if you prefer to have a professional manage your money, click here to learn the ways to get ahold of us to discuss your situation.