Lower Earnings, Higher Stock Prices: The Voting Machine
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“The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.”- Graham and Dodd, Security Analysis
Earnings drive stock prices, so says investing lore. As earnings rise, stock prices move higher. As earnings fall, stock prices move lower. If it were only that simple.
With the S&P 500 hitting new all-time highs, earnings should be exploding higher. To the contrary, for the 2nd consecutive quarter, they are moving lower. With 92% of companies reported, S&P 500 earnings have declined 13% in the first quarter of 2015. This follows a 14% decline in the prior quarter.
What about the top line? Surely this just an accounting issue.
But sales growth is also showing a decline, -1.8% over the prior year, the first year-over-year decline since 2009.
What about sectors? Surely the decline in earnings is solely due to Energy, which had a terrible quarter due to the collapse in Crude.
But six out of the ten major S&P 500 sectors showed year-over-year declines, including both consumer sectors, which were supposed to have benefited most from the decline in gas prices.
So how in the world are stocks hitting new all-time highs? As Graham and Dodd said, the stock market is a voting machine that responds to factual data only as they effect the decisions of buyers and sellers.
Buyers and sellers have become fixated on one fact and one fact alone: easy monetary policy. While earnings and economic data have been weak in 2015, the Federal Reserve has responded by becoming increasingly dovish.
Expectations for the long-awaited rate hike off 0% have been pushed all back to December, with Fed Fund futures now predicting there is only a 50% probability of that occurring. We are only a hair’s breadth away from expectations moving to 2016.
And so it is not earnings that drive stocks prices but the multiple investors are willing to pay for those earnings. While earnings have declined, investors have been happy to pay a higher and higher multiple as long as interest rates remain at 0%.
When will that change? When investors choose to respond to other data beyond monetary policy or when the Fed chooses to finally raise interest rates after nearly seven years. Not as intellectually satisfying as “earnings drive stocks prices,” but that’s what actually moves markets in the short-run.