Commentary | Jan 24, 2020

What Drives Stock Market Returns?

share

Unfortunately, there isn’t (and probably never will be) a conclusive answer to this multi-trillion-dollar question. However, in the following paragraphs we share some useful insights.

Economic Growth and Profits

Two principle drivers of stock prices are economic growth and corporate profits, with the former exhibiting a strong influence over the latter. Although companies’ earnings are affected by a myriad of factors, the state of the economy is the principal driver of earnings growth.

However, the link between earnings and stock market returns is not as strong as one might believe. Since 1999, the correlation between annual earnings growth and returns for the S&P 500 Index has been only 19%, which does not meet the threshold of statistical significance. The weakness of this relationship was clearly illustrated during 2009, when the S&P 500 rallied over 26% as company earnings plummeted.

Markets are Forward Looking

Based on the notion that markets are forward looking, and that they reflect earnings expectations rather than current profits, we analyzed the relationship between changes in profit growth (using consensus forecasts for the next 12 months) and stock market returns.

Since 1999, the correlation between annual changes in earnings expectations and returns for the S&P 500 has been a statistically significant 55%. In addition, the “false signal” problem, whereby changes in profit forecasts and returns move in opposite directions, has been minimal. For example, during the recovery of 2009, earnings expectations rose in sync with stock markets.

Not Even a Crystal Ball

While earnings expectations exhibit a significant, yet far from perfect correlation to stock market returns, the fact remains that nobody can accurately and consistently predict company earnings (including companies themselves). During inflection points in the economic cycle, profit forecasts can rapidly shift between euphoria and despair, thereby causing wild fluctuations in stock prices.

Even if people could accurately predict companies’ future earnings, they would still be unable to accurately predict stock market returns. Market participants pay different prices for a dollar of either current or forward earnings at different points in time. There have been times when market participants were willing to pay $10 for $1 of earnings, and others when they were willing to pay $20 for the very same $1. In other words, stock prices can double or halve with no change in either current or expected earnings.

Whereas changes in interest rates certainly have a strong influence on earnings multiples, they by no means tell the entire story. For example, neither interest rates nor elevated profit expectations can explain the nosebleed-inducing multiples that prevailed at the peak of the tech bubble in late 1999/early 2000.

What’s Really Driving the Bus

Given that market multiples and earnings forecasts are the primary drivers of stock prices, then it follows that the key to accurately predicting market returns lies in ascertaining which factors have the most influence on them.

The simple (and maddening) fact is that investor sentiment exhibits by far the most powerful influence on both earnings forecasts and multiples. Investors are largely driven by their emotions, which are subject to sudden and large shifts. As recently as the fourth quarter of last year, markets dropped sharply as investors quickly shifted from a “what could possibly go wrong?” to a “run for the exits” mentality.

At Outcome Wealth Management, we apply sophisticated statistical analysis and machine learning techniques to large amounts of data to identify changes in sentiment regimes. Our ability to identify such shifts enabled our clients to participate in the rising markets of 2017 and avoid losses as markets tumbled in the fourth quarter of 2018.

We are confident that we will continue to achieve this combination of upside participation and downside protection in the future, thereby enabling our clients to more effectively compound their investments over the long-term.