Many factors influence stock prices in the short-term: news events, investor sentiment, interest rates, etc. But in the long-term, stock prices are very highly correlated with company earnings.
That makes perfect sense, as stocks are tiny ownership slices in individual companies. When a company earns more money, it is more valuable and the owners prosper. When a company earns less, it becomes less valuable and the owners earn less.
Alas, when it comes to earnings and the short-term price movements of stocks, many other factors obscure this relatively straight-forward relationship, sometimes for years at a time. For example, the central banks of the world have been so activist over the past seven years that their actions have often felt like the primary drivers of stock returns. In the short-term, they have been. But the importance of company earnings always comes back to the forefront eventually.
Earnings have been out of the spotlight for so long that many newer investors may not understand how changes in earnings have tended to impact stock prices in the past. Consider this a very brief introduction to the topic.
Earnings per share & P/E Ratios
Four times a year, publicly-traded companies announce their earnings for the prior quarter. By tracking these earnings releases, it's relatively easy to determine what baskets of companies, like the 500 stocks in the S&P 500 Index, have earned in aggregate. This gets tracked over time, allowing investors to see the ebb and flow of corporate earnings.
Generally speaking, when earnings are rising, stocks do well, and vice versa. But it's not as much of a straight-line relationship as you might expect. That is due, in part, to how much investors are willing to pay for each dollar of earnings. When earnings are rising and investors are optimistic about the future, they're usually willing to pay higher prices. On the flip side, when earnings are falling and investors are pessimistic, they won't pay as much.
This is where the often-discussed "P/E Ratio" enters in. The P/E ratio is a simple gauge to tell us how the market's current valuation compares to the past.
P/E is simple to calculate. It's the "Price" of the index (or stock, or whatever is being measured) divided by the "Earnings" that index (or stock, etc.) has generated. Using the S&P 500 Index as an example, the index value recently has been around 1,900 and earnings over the prior 12-months have been around $90 per share, which gives a P/E ratio of around 21.
That's about where the simplicity ends, unfortunately. We've written numerous times about why we're not big fans of using the P/E ratio to try to understand the market and predict where it's heading next. That's partly because there are several versions of P/E, each with their own idiosyncracies, strengths and weaknesses. And it's also largely because as we noted earlier, in the short-term, factors other than valuation can dominate for years at a time.
That said, while P/E ratios may not be super helpful in indicating what the market will do next, the trend of earnings is still important. A decade ago, that statement would have qualified me for the "Captain Obvious" award. But investors have been so distracted in recent years by factors other than earnings that I suspect many aren't even aware that earnings have been in significant decline for some time now.
There are plenty of sources saying basically the same thing about earnings right now: with about half of the S&P 500 companies having reported their Q4 2015 results, earnings are expected to come in 5-6% below the same period last year. This will be the third consecutive negative quarter for earnings (which some find significant). It appears that earnings peaked over a year ago, back in the third quarter of 2014, and have declined about 14% since then.
(I'm going to shift here from what has been a factual explanation into something more speculative. The type of analysis I'm about to engage in is of a type I don't usually put much faith in, but I think it will help illustrate how these pieces fit together into something semi-useful. I'm basically saying it's good for you to understand the process that follows, but don't put much weight on the results.)
Having looked at several reports from services that track all this earnings stuff, I'm going to estimate that when all the Q4 earnings numbers are in, the 2015 total earnings per share will be around $90. It may be a little higher or lower — I'm purposely not going to be too precise here so as not to give the illusion that any of these conclusions are much more than darts sailing at the wall.
If earnings (E) are $90, and the S&P 500 Index price (P) is currently ~1,900, that gives us a P/E ratio of around 21. But I just mentioned that earnings peaked in the 3rd quarter of 2014...when the P/E ratio was much lower, at just 18.5.
Why should investors be willing to pay substantially more for each dollar of earnings today, when earnings have been falling for the better part of a year and are 14% lower than they were in the 3rd quarter of 2014? There's no good answer to that question that I can see. So a natural thing for an analyst to do would be to say, "What happens if we apply that earlier 18.5 P/E ratio to today's $90 earnings amount?" The answer is the S&P 500 would fall to 1,665, a drop of about 13% from today's level.
Then another analyst might say, "Really, we should adjust the P/E ratio back to the level it was at when earnings were last in this $90/share range, which was the end of 2012." The P/E ratio was around 17 at the time, so that calculation would take us to 1,520 on the S&P 500, a drop of about 20% from here.
Another analyst might look at the average trailing 12-month P/E ratio to tell us how much the market should fall to get back to an "average" valuation, while yet another might look at the average P/E ratio at the end of bear markets to tell us how far the market might be expected to drop overall. And on and on. These may be interesting scenarios, but they're not particularly useful, because P/E ratios tend to be reflective of specific, current circumstances rather than being predictive.
While I don't generally put much stock in the type of analysis above that says "the market should move X%" because it really deserves a different P/E ratio, I do think the trend of declining earnings is potentially important. And I agree, generally if not specifically, with the idea that if reasons to expect that declining earnings trend to turn around don't surface relatively quickly, it's hard to support the current valuation of this market, which is high by historical standards. Add that all up and basically I'm saying earnings are a valid/likely reason why stock prices peaked nearly a year ago (May 2015) and why they've been declining lately. And there could be more downside left in that equation if more hope for an earnings rebound doesn't materialize in the months ahead.
Thankfully, you don't need to try to stay up to date on all the earnings news. I'm discussing it today because it's a foundational piece of knowledge for investors to have. But all of the earnings information is reflected in the price movements of the market and the individual securities that make the market, which means it's already factored into the momentum formulas upon which the SMI strategies are built. If you allocate appropriately between those strategies, then follow-through on them diligently, you don't need to try to keep up with the perpetual earnings news.