The most important drivers of stock prices are earnings and expectations for earnings growth. Earnings, or net income, is literally the bottom line.
So it surprises no one when stock prices fall as expectations for earnings growth decline.
This relationship, however, isn’t always observable in the short-term. In fact, through most of this bull market we have seen stock prices actually go up despite earnings expectations coming down. This is a trend we have been keeping track of for years. And according to Morgan Stanley’s Adam Parker, the trend in earnings revisions has been negative since 1976, a period of time when stocks have trended higher.
“During the third quarter, analysts lowered earnings estimates for companies in the S&P 500 for the quarter,” FactSet’s John Butters wrote in a note on Friday. “The Q3 bottom-up EPS estimate (which is an aggregation of the estimates for all the companies in the index) dropped by 3.5% (to $US29.01 from $US30.07) during this period.”
“The value of the S&P 500 also declined during the third quarter,” Butters added. “From June 30 through September 30, the value of the index decreased by 6.9% (to 1920.03 from 2063.11). As a result, the third quarter marked the second consecutive quarter in which both the bottom-up EPS estimate and the value of the index fell during the course of the quarter. The last time the index witnessed a decline in both the bottom-up EPS estimate and the value of the index for two straight quarters was four years ago (Q2 2011 and Q3 2011).“
In the long run, the relationship between stock prices and earnings seem to revert to long-term averages. This is good news for patient investors who are willing and able to ride out short-term swings in the market as they wait for value to come into fruition.
But in the short run, you’re taking a big gamble trading on the assumption that these things work themselves out in a timely manner.