One of the worst parts of any bear market is the feeling that there is always something else to worry about that hasn’t happened yet and that could make things worse.
The future risk that everyone on the bingo card has been in the market for months and months now has been the recession caused by the Federal Reserve.
If a recession occurs anytime soon, it will certainly be the most pronounced recession in history that everyone has previously predicted.
With the possibility of a recession looming high, the next logical step for many market watchers is to anticipate a fall in corporate earnings.
Corporate earnings have held up well this year, but they’re sure to drop if we go into a widespread economic slowdown, right?
This seems logical to me.
Stock market valuations are almost always a function of price to another variable. price to profit. price to sales. Price to cash flow.
Sure, the price has already gone down but what happens when profits, sales and cash flow go down next? The stock market is sure to go down even more, right?
It is possible but the relationship is not entirely clear with these things.
In the very long run, the stock market controls fundamentals like earnings, dividends, and cash flow. But even over a decade of timeframes, these underlying drivers don’t always have the effect you might assume.
Use of historical data from Robert SchillerI looked at earnings growth by decade compared to total returns for the stock market:
There are times when these things line up. Earnings growth was appalling in the 1930s and 2000s, and so was the stock market.
Earnings growth was subdued in the 1940s, 1990s, and 2000s, and the stock market followed suit.
But look at the 1970s – amazing earnings growth with poor stock market performance. Earnings didn’t grow that much in the 1980s, but the stock market shot up. The same was true in the 1950s.
There are much more variables when it comes to stock market performance than just earnings.
The same is true for the shorter time frames.
Between 1930 and 2021, S&P 500 corporate earnings were positive 61 times from year to year and negative 31 times.
So the gains were growing two-thirds of the time and one-third the gains shrinking. This makes sense when you consider that the stock market is positive roughly 3 out of every 4 years, on average.
The tricky part here when trying to use profits to hamper the stock market is that the ups and downs don’t always line up perfectly.
If you were to invest in the stock market only when your earnings rose year-over-year, your average annual return would have been 10.2%.1
This seems logical. When earnings are strong, stocks are expected to be strong.
However, if you were to only invest in stocks when your earnings were declining year over year, your average annual return would have been 9.8%.
It doesn’t make sense but the stock market doesn’t always make sense. Sometimes it is an overreaction. At other times he ignores. Sometimes he runs the future. Other times it lags behind what comes next.
If we delve into the performance over the positive and negative earnings years, it won’t make matters clear either:
Over the past 90 years, the stock market has been more likely to see positive returns, double-digit returns, and higher years of 20% or more when earnings decline from year to year. The market was also likely to experience a double-digit loss but not by much.
It is possible that stagnant earnings will lead to another drop in the stock market.
But it is certainly not a foregone conclusion.
The stock market can’t predict the future but it’s hard to believe that the current bear market doesn’t take into account at least the possibility of lower profits.
Knowing what is priced at current levels is not easy, so it is difficult to determine what the market expects to profit if we enter a recession.
Even if you know what will happen to earnings in the coming years, it may not help you predict what will happen to the stock market.
Michael and I talked about upcoming recessions, earnings, and more in this week’s Animal Spirits video:
participation in the complex So you don’t miss an episode.
The relationship between earnings and bear markets
Now this is what I was reading recently:
1Earnings are reported late so there is no way to know in advance but the point remains nonetheless.