Myth-Busting: Earnings Don’t Matter Much for Stock Returns

If earnings don’t matter, what does then?

March 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • There is no strong relationship between stock returns and earnings
  • This is regardless of current or expected earnings
  • High earnings growth does not lead to high P/E ratios

INTRODUCTION

What drives stock returns? Earnings, right? So, what drives earnings? Likely economic growth. After all, it’s much harder for companies to expand their sales and profits in a sputtering economy.

However, the relationship between equity returns and economic growth is more illusion than reality. It may make logical sense, but there is little actual data to support it.

For example, China’s economy has expanded at a pretty consistent and impressive pace, about 10% per year, since 1990. That should have provided ideal conditions for Chinese stocks to flourish and generate attractive returns. But investing in Chinese equities was not such a smooth ride. The Shanghai Composite index is up since 1990, but the trajectory has been anything but consistent, with multiple 50% drawdowns.

This lack of correlation has a simple explanation. The Chinese stock market has been historically dominated by largely unprofitable state-owned enterprises (SOEs) and has not reflected the otherwise highly dynamic economy.

But China is hardly an outlier. Elroy Dimson, Jay R. Ritter, and other researchers have demonstrated that the relationship between economic growth and stock returns was weak, if not negative, almost everywhere. They studied developed and emerging markets across the entire 20th century and provide evidence that is difficult to refute (read Equity Factors & GDP Growth).

Their results suggest that the connection so often made between economic developments and stock market movements by stock analysts, fund managers, and the financial media is largely erroneous.

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

EARNINGS VERSUS STOCK RETURNS<