Do earnings drive stock returns?

by Finploris
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Actual scientific data show that the relationship between equity returns and economic growth does not correspond to reality. In the past decades, some economies have expanded at a consistent and high pace. But their corresponding stocks have not generated attractive returns. On the contrary the investing in these equities was a wild ride. The trajectory has been volatile with dramatic drawdowns.

In developed as well as emerging markets the relationship between economic growth and stock returns was weak across the entire 20th century. In some economies the explanation lies in the fact that their stock market has been dominated by largely unprofitable state-owned enterprises.

Do at least earnings drive stock returns? The perspective does not change and the relationship does not hold true. The rolling returns for one, five or ten years of both time series using data from Robert J. Shiller at Yale University indicate even divergent movements. The correlation between earnings growth and stock market returns was representative for the US stock market predominantly zero over the last century. There is a lack of correlation between the current earnings growth as well as the earnings growth for the next 12 months and the stock returns.

In addition, there was just a week correlation between earnings growth and high or low P/E ratios. The average P/E ratio was indifferent to the expected earnings growth rate over the next 12 months. Earnings don’t drive stock returns. Nevertheless, they should not be totally neglected. The stock market doesn’t perfectly value companies based on discounting future cash flows. Sometimes animal spirits drive the stock returns more strongly than fundamentals.

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