Stock Prices And Earnings

We invest in stocks to participate in the growth (and dividend income) of the companies who's shares we own. Earnings growth is a key component to any company's future value. As we who spend our time monitoring this kind of stuff (to determine if there is value in ownership at current share prices) are want to do, we are inherently more interested in what is in store down the road as opposed to what is already historical information, because we want to build a sensible case for buying whether it be now or at some future point in time.

So we cast about in the available data to attempt to come up with some reasonable way to determine relative value. 

In the chart above, the dark blue line represents the expected future (12 months) earnings per share of the companies that make up the S&P 500 index. The lighter blue line is the composite of the companies' share prices.

Back in the after-math of the 2007-2009 recession, shell-shocked investors, somewhat reticent to take on the risky ownership of stocks again, had to be convinced that earnings growth could be sustained, so there was more of a "show me first" mentality: earnings had to lead share prices higher. Bravery was rewarded with some pretty decent returns until 2015.

As is the normal human reaction, those who joined the party well after it was in full swing (with many advisors shouting the rally cry of 7% returns for balanced portfolios as a layup, without the required disclaimer that past returns were no guarantee of future growth), created a buying spree from mid 2014 that drove share prices past the expected future earnings (light blue line intersects and overtakes the dark blue line), rendering share prices rather expensive on a relative basis. 

Late in 2015 a realization of over-valuation brought about a correction of share prices and a return to relative value. The light blue line fell back to the dark blue line then and again in early 2016 and with it all those portfolios that had been late to the party, suffered.

Donald Trump came to the rescue with promises of tax reform, infrastructure spending and deregulation and stock prices took off in 2017. 

The problem? Stock prices just built in too much good news and stayed expensive relative to earnings. Earnings did jump higher in early 2018 (as tax reform gave them a temporary boost), but stock prices stayed well ahead with investors believing that it would all go on forever! Not so with the drop in share prices in December back to reasonable value.

Now we are seeing earnings growth expectations rolling over (dark blue line turning down inside the red circle on the chart above) and below:

But share prices have bounced back to lofty (relative to earnings) levels. Which means that buyers are still active. Until they are not. History will tell us that what is expensive will not remain so for very long.