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Throughout global financial news, corporate earnings regularly hog headlines. Pundits frequently dwell on whether corporate earnings per share—one measure of corporate profitability—met, beat or missed analysts’ expectations. Analysts themselves spend countless hours trying to predict future earnings. The general consensus seems to presume earnings growth (or lack thereof) will dictate stocks’ direction almost on a one-to-one basis. However, data and logic suggest earnings alone don’t predict equity market returns.

Using America’s S&P 500 Index for its long dataset of quarterly corporate earnings, we don’t see a demonstrable relationship between earnings growth and equity returns. (Exhibit 1) Some quarters had nicely positive earnings and returns. In other quarters, both were negative. Sometimes they moved in opposite directions. In many cases, earnings and returns moved in the same direction but at vastly different magnitudes.

Exhibit 1: Earnings Aren’t Predictive of Market Returns

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Source: FactSet, as of 10/9/2019. S&P 500 Total Return Index quarterly return in USD and S&P 500 year-over-year earnings growth rate (quarterly), 31/12/2010 – 31/3/2019. Presented in US dollars. Currency fluctuations between the US dollar and Canadian dollar may result in higher or lower investment returns.

Exhibit 1 also presents a crucial conundrum: By the time companies announce earnings, equity markets have long since moved on. The chart shows earnings and market return in a given quarter. But earnings for any given quarter are announced the following quarter, once the corresponding market returns are in the books. In 2009, for instance, equity markets soared in the second quarter, whilst companies were announcing terrible Q1 earnings results.[i] Investors were seemingly looking ahead to the profitability that would return later in the year. More recently, as shares plunged in Q3 2011, companies were announcing strong earnings growth for the previous quarter—but fears of the eurozone’s impending collapse were a much more powerful influence on investor sentiment than strong profitability, in our view.

Recent history shows falling earnings aren’t necessarily bearish. It isn’t unusual for earnings to drop for a short spell during a bull market, then resume growing. In 2015 – 2016, S&P 500 earnings fell on a year-over-year basis for five straight quarters, but the S&P 500 Index rose 3.4% during that span.[ii] The broad index’s earnings were negative predominantly due to the Energy sector, which suffered as Brent crude oil prices plunged -75.2% from 30/6/2014 to 20/1/2016 due to a massive supply influx from US shale oil producers. Energy earnings’ steep declines were enough to pull total earnings negative even as profits in other sectors grew. Excluding Energy, earnings held up largely ok.

Exhibit 2: One Sector Can Skew Earnings Overall

Source: FactSet as of 13/9/2019. Year-over-year S&P 500 earnings growth, Energy sector earnings growth and S&P 500 excluding Energy earnings growth, Q1 2015 – Q3 2016.

In other words, negative earnings didn’t indicate market-wide weakness. Equity markets globally experienced a correction (sharp, sentiment-driven move of around -10% – -20%) during this stretch, but not a bear market.

More recently, S&P 500 earnings fell slightly in Q1 and Q2 2019. Analysts expect another small drop in Q3. But this is because the US tax cut passed in late 2017 gave businesses a large one-time cost cut throughout 2018. This resulted in swift year-over-year earnings growth last year but also set a high bar for 2019 earnings to clear. That they have fallen only incrementally—just -0.3% y/y in Q1 and -0.4% y/y in Q2—implies resilience, in our view.[i] Earnings also fell for a spell in the late 1990s before reaccelerating. That pullback didn’t end what was then history’s longest bull market.

It isn’t unusual for earnings of a broad index to weaken late in an expansion. In an expansion’s first year, earnings usually pop high as weak profits during the recession provide a low base for year-over-year growth. In the next few years, cost-cutting programs launched during and after the recession can continue boosting profits, generating fast growth. As an expansion ages, it becomes more difficult to maintain high year-over-year growth rates since the year-over-year benchmarks rise and companies exhaust their ability to cut costs as higher demand forces them to ramp up production. Then, revenue growth becomes the primary driver of profits and an increasingly important signal of the company’s health. Notably, S&P 500 revenues continued growing in 2019’s first half, even as earnings contracted.

Many analysts try to work around these problems by using ratios like the forward price-to-earnings ratio (FPE, which compares a stock price to expectations for earnings over the next year) and cyclically adjusted price-to-earnings ratio (CAPE, which compares a stock price to the past 10 years’ worth of earnings adjusted for inflation), arguing they show whether shares are expensive relative to future earnings, in the case of FPE, or relative to recent history, in the case of CAPE. Yet FPE, in our view, isn’t predictive either. We think it is a gauge of sentiment but doesn’t signal market turning points. Conventional wisdom focuses on the numerator—share price—arguing rising (or falling) share prices can cause FPE to rise (or fall), making shares seemingly expensive (or cheap). This suggests higher current prices are bearish, whilst lower current prices are bullish. But this ignores the denominator—earnings. An FPE can rise if earnings expectations fall more than the share price. It can fall if earnings rise more than the share price. This is why FPEs are often sky-high early in a bull market, when share prices bounce before earnings do. That isn’t a signal of an overvalued market. The other problem with using FPEs as timing tools is that high FPEs can get higher and low FPEs can get lower. No set level is a trigger for a new bull or bear market. CAPE doesn’t even really reflect sentiment well, since its construction renders it even more backward-looking than quarterly earnings. CAPE today would include extreme times like the global financial crisis and eurozone debt crisis, which have no bearing on profitability today. The inflation adjustment adds further skew, in our view, because it creates a false comparison. CAPE compares nominal prices to inflation-adjusted earnings using an esoteric measure of inflation. Yet investors earn nominal, not inflation-adjusted, earnings. In our view, the extra statistical massaging renders CAPE meaningless.

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[i] Source: FactSet, as of 11/9/2019. Statement based on S&P 500 total return in USD, 31/3/2009 – 30/6/2009, and year-over-year percentage in S&P 500 corporate earnings, Q1 2009.

[ii] Source: FactSet, as of 11/9/2019. S&P 500 total return in USD, 31/3/2015 – 30/6/2019.

[iii] Source: FactSet, as of 13/9/2019. S&P 500 year-over-year earnings growth rate, Q1 2019 – Q2 2019.

Fisher Asset Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein


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