Earnings growth is the key to a rising stock market.
When you buy a stock, you are buying a stream of earnings in the future…
If earnings don’t grow, or if the market perception of earnings doesn’t change, a stock won’t rise. But if earnings – or market expectations for earnings – do change, stocks move.
And lately, you’ve probably heard a lot of worries about slowing earnings growth. Everyone’s wondering when the bull market will finally grind to a halt.
If you follow the numbers, you might be worried, too… But today, I’ll show you that the most widely accepted numbers about earnings – the ones Wall Street analysts and money managers track so closely – are completely wrong.
More importantly, when you use the right metrics, you’ll see immediately what earnings really say about the stock market. So let’s begin…
Earnings growth should move closely in line with stock returns. But according to Wall Street’s numbers, that’s not what’s been happening.
Take a look at the chart below. It shows the market’s movements over the past two decades. And while it’s had some ups and downs, you can see the overall trend is unmistakably up…
The S&P 500 Index peaked at more than 1,500 in March 2000. Then, as the tech bubble burst and the recession of 2000-2001 approached, the bottom fell out.
The market reached new highs again in mid-2007, ahead of the Great Recession. And it wasn’t until 2013 that the market broke its 2007 highs, having rallied for the past six years.
So it must have made those new highs because of earnings growth and improving profits, right?
Well, not according to Wall Street’s numbers. Take a look at the chart below (you can click to expand the picture). It highlights U.S. corporate profitability in terms of as-reported return on assets (“ROA”)…
You can see the problem immediately. This chart does not track the market’s performance at all.
While profitability trends from 2006 to 2008 matched up with the market’s rally versus 2000, in every year since, profits have never come back to those levels. In fact, from 2013 to 2015, as the market rallied higher, as-reported ROA fell to historic lows.
So why on earth has the stock market been making new all-time highs if earnings power is declining? Does the market just not get it?
Not exactly. It turns out the numbers are lying to us – the as-reported numbers, to be specific.
You see, generally accepted accounting principles (“GAAP”) are full of distortions. My team and I use our proprietary system to fix them. And when we look at the real numbers for corporate profitability (the blue bars below), everything comes into much clearer focus…
The above chart explains U.S. corporate performance in terms of ROA (dark blue bars) versus the performance sell-side analysts expect over the next two years (light blue bars) and what the market is pricing in at current valuations (red bar).
When we remove the noise associated with GAAP distortions – especially around issues like acquisition distortions, research and development (“R&D”) expensing, excess cash, and stock option expense – it becomes clear that the economy is in a good place.
In fact, U.S. corporate profitability is at all-time highs.
Adjusted ROA has consistently reached higher highs, and higher lows, through cycles. As companies become increasingly technologically advanced and management teams become more responsible with their investments, profits are improving.
With the right data, the movement of the S&P 500 over the past 20 years makes more sense…
After dropping in 2001 and 2002, adjusted ROA levels reached 10% in 2006 and 2007. These levels exceeded the levels of 1999 and 2000, just as the market was making new all-time highs.
Then after dropping in 2008 and 2009, adjusted ROA again reached new peaks in 2011 and 2012. By early 2013, the market was making new all-time highs.
After falling due to energy-market headwinds from 2013 to 2015, adjusted ROA is now at 13%. This is more than double the long-term global corporate average!
The recovery in ROA has also lined up with the market’s ability to make new all-time highs from 2016 to this year.
Each time over the past 20 years, the as-reported numbers said corporate profitability only approached prior highs before rolling over… but the real numbers said companies were breaking records. Earnings growth – and growth in profits – has driven stocks higher.
Now, one question remains… “Why does this matter? Stock markets are at all-time highs, and everything says stocks are still expensive. Prices have to fall from here.”
On the surface, the folks who say this have a point. The Case-Shiller price-to-earnings (“P/E”) ratio – a typical measure of valuation – is at historically high levels, and traditional P/E ratios are well above historical averages.
But the as-reported P/E ratios are lying just as much as the as-reported returns are.
Remember the red bar in the chart above… It represents the returns the market is pricing in right now. While U.S. companies are producing 12% ROA, the market is expecting returns to fall going forward. Market pricing is NOT overvalued – it’s actually at a discount to today’s profits.
The numbers are clear… The market needs to continue to rise in order to correctly price reality. Far from shrinking, corporate profitability is higher than ever. And that means this bull market will likely continue.
Regards,
Joel Litman
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Source: Daily Wealth