Myth-breaking: Earnings are not very important for stock returns


What drives a stock return? Earnings, right? So, what drives the earnings? Probably economic growth. After all, it is very difficult for companies to expand their sales and profits in a crippled economy.

However, the relationship between equity returns and economic growth is more illusory than real. This may sound logical, but there is little real information to support it.

For example, China’s economy has grown at a steady and impressive pace of about 10% per year since the 1st China0. This should have provided ideal conditions for the development of Chinese stocks and the creation of attractive returns. But investing in Chinese equity has not been such a smooth journey. The Shanghai Composite Index has risen since 1990, but the trajectory was consistent with a 50% drawdown.

There is a simple explanation for this lack of reciprocity. The Chinese stock market has historically been heavily influenced by nonprofit state-owned enterprises (SOEs) and otherwise did not reflect a highly dynamic economy.

But China is rarely external. Elroy Dimson, J. R. Ritter, and other researchers have shown that the relationship between economic growth and stock returns was weak, if not negative, almost everywhere. They study developed and emerging markets throughout the twentieth century and provide evidence that is difficult to refute.

Their results suggest that the connection between economic development and the movement of the stock market is often misunderstood by stock analysts, fund managers and financial media.

But what about earnings driving stock returns? Is that relationship still true? After all, Finance 101 teaches that a company’s valuation represents its discounted future cash flow. So let’s see if we can at least verify that connection.

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Earnings vs. Stock Returns

To explore the relationship between U.S. stock market returns and earnings growth, we first calculated the five-year rolling return of both time series using data from Yale University’s Robert J. Schiller. From 1404 to 2020, earnings growth and stock returns converged over a period of time, however, there were decades when they were completely isolated, as highlighted by a correlation of less than 0.2.

If we change the rolling return calculation window in one or 10 years, or if we use real instead of nominal stock market prices and earnings, the outlook does not change. The correlation between U.S. stock market returns and earnings growth was virtually zero in the last century.

U.S. stock returns and earnings: Five-year rolling returns

Source: Robert J. Schiller Library, Factor Research
Earnings growth was won at 350%.

Perhaps the lack of correlation between stock returns and earnings growth is because investors tend to focus on the expected instead of the current growth. A company is evaluated based on future cash flow discounts.

We tested this estimate by focusing on earnings growth for the next 12 months and assuming investors are the perfect predictor of earnings for U.S. stocks. We consider them as super investors.

But the previously known rate of earnings growth did not help these superinvesters to spend time in the stock market. Forward income growth was negative at the worst possible percentage. Otherwise, whether the rate of earnings growth was positive or negative had little effect on stock returns.

US Stock Returns: Next 12 Month Earnings Rise vs. Stock Returns, 1900-2020

Chart showing US stock returns: earnings growth vs. stock returns over the next 12 months, 1900-2020
Source: Robert J. Schiller Library, Factor Research
Earnings growth was won at 100%.

Income growth vs. P / E ratio

We can extend this analysis by investigating the relationship between earnings growth and P / E ratio. Rationally, there should be a strong positive relationship because investors reward high-growth stocks with high multipliers and penalize low-growth stocks with lows. Growth investors have repeated this mantra to explain the extreme valuation of technology stocks like Amazon or Netflix.

Again, the data do not support this type of relationship. The average P / E ratio was indifferent to the expected earnings growth rate for the next 12 months. In fact, higher progress has resulted in slightly lower P / E quality than average.

If the focus was current earnings, our explanation might be that an increase in earnings leads to an automatic decrease in the P / E ratio. But with forward income, these results are less intuitive.

US stock returns: earnings growth vs. P / E ratio for the next 12 months, 1900-2020

Chart showing US stock returns: earnings growth vs. P / E ratio for the next 12 months, 1900-2020
Source: Robert J. Schiller Library, Factor Research
Earnings growth was won at 100%.

More thoughts

Why are earnings so low for stock market returns?

The simple explanation is that investors are irrational and the stock market is not the perfect discount machine. Animal spirits are important if not more than basic. 1 A great example of a tech bubble in the late 1990s and early 2000s. Many flying companies of that era such as or Webvan had negative earnings but share prices rose.

Does this mean that investors should completely ignore earnings?

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Many are already doing so. Millennials, in particular, make big bets on GameStop, for example, and some hedge fund managers follow motion strategies. And while the former rarely seems like a good investment, the latter is a perfectly acceptable strategy that requires no earnings data.

So while earnings should not be completely ignored, investors should also not assume that they are the driver of stock returns.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.

Photo Credit: © Getty Images / Andrew Holt

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Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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