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What happens to share prices is earnings fall?


What happens to share prices is earnings fall?

In this week’s video insight Roger discusses the most obvious and predicted recession ever and a commensurate collapse in earnings. Earnings are holding up relatively well. But if they fall what happens to prices? Well, it turns out the relationship isn’t as clear as you might expect.


Roger Montgomery:

I have just written and published a blog post suggesting a significant amount of deterioration

in jobs and earnings needs to occur for the world’s most predicted recession to occur, one that justifies interest rate market expectations for more than three rate cuts before the end of January 24 – which is in just seven months’ time.

For those rate cuts to transpire we may also need inflation to plunge from its current annualised rate of 3.6 per cent to around 2 per cent. But even if that happens, the Fed might refrain from cutting rates until it sees something else is breaking, like the economy or earnings.

As I reported in my blog post U.S. quarterly earnings season is heading towards three-quarters complete and earnings growth is negative 3 per cent year-on-year. That’s a solid 6 to 9 per cent better than what was expected and suggests jobs are secure and the economy is not collapsing towards a recession. To be fair the dodgier results tend to be reported late but I cannot imagine a deterioration from the final quarter of companies significant enough to meet the pre-reporting season growth expectations of negative nine-to-twelve per cent.

And in any case, even if earnings were to decline, it’s not guaranteed the market would collapse.

And that’s what this video is about.

When it comes to investing in equities during anything other than a raging bull market, it seems there is always something new to worry about, something that hasn’t happened but is likely to make investing now too risky. Right now, that’s the most obvious and predicted recession ever and a commensurate collapse in earnings.

As I just mentioned earnings are holding up relatively well. But if they fall what happens to prices? As you would well know prices had come down a long way into December last year and now they are rallying. But what happens if sales and earnings or cash flows fall?

Well, it turns out the relationship isn’t as clear as you might expect.

One analyst took the time to examine historical data from Professor Robert Shiller, comparing earnings growth by decade, to U.S. stock market returns.

In the 1930s and 2000s there was a high level of correlation between the stock market and earnings, both collapsed.

In the 1940s, 1990s and 2010s the market surged a couple of hundred per cent along with soaring earnings.

But that’s where the positive correlations seem to end. The 1970s saw superb earnings growth but a return of about 4.5 per cent for the S&P500. The following decade, the 1980s, the market surged even though earnings didn’t and that was a repeat of the 1950s.

Some of you will be saying, that’s all very well over decades, but I don’t have decades. What about shorter periods? 

Looking at the 91 years from 1930 to 2021 S&P 500 annual corporate earnings were positive 61 times and negative 31 times. And once again the market’s rises and falls don’t correlate perfectly at all.

If you knew in advance that earnings would rise, and only invested in those years, your return would have been 10.1 per cent per annum. And yet, if you only invested in the year’s earnings fell, the average annual return would be 9.8 per cent. Of course, to achieve that result you’d have to have invested in all 31 negative years and there would have been some shockers!

And how about this interesting fact; Over the 91 years to the end of 2021, the S&P500 saw more positive, and double-digit returns, as well as years of greater than 20 per cent returns when earnings were down from one year to the next. Double digits losses were also more likely, hence my comment that achieving the average return would require a seriously strong stomach.

So, you achieve a higher return investing in years with positive growth but its only marginally higher. The real benefit is the lower volatility of returns. And keep in mind the biggest market collapses in the last 100 years have correlated with substantial earnings declines. 

But in the absence of a recession, which the interest rate market seems to be predicting but Jerome Powell of the U.S. Federal Reserve is not, it seems a substantial correction in earnings is unlikely.

And even if earnings decline further – than what seems to be a current rate of minus 3 per cent year on year – there is no certainty the market will slide. 

In fact it’s worth remembering right now earnings are falling 3 per cent but both the S&P500 and the Nasdaq are up for the year – the S&P500 is up nearly 10 per cent and the Nasdaq is up nearly 20 per cent.

You can read my previous blog post below.

Why I think tech and small caps could rally this year


Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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