Stock Prices Usually Beat Fundamentals to the Drop

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(Bloomberg) -- U.S. stocks have been shaky lately. Volatility spiked in February after years of calm, and the market continues to be bumpy. Meanwhile, the S&P 500 Index has gone nowhere this year, down 1 percent through Monday.

Investors, however, needn’t fear that the recent volatility will turn into a rout because “the fundamentals are strong.” Or at least, that’s the refrain Wall Street analysts never tire of crooning for investors.

It’s true that companies are awash in profits. Inflation-adjusted earnings for the S&P 500 have never been higher, according to numbers compiled by Yale professor Robert Shiller. The S&P 500’s gross margin of 33.7 percent for 2017 is just shy of the record 34.1 percent notched in 1998 and again in 1999 at the height of the of dot-com boom. Its profit margin of 9.2 percent is just short of the record 9.6 percent achieved in 2013. And earnings are beating expectations at a record pace, according to Bloomberg News.

The problem is that fundamentals have little to do with stock prices in the short run. I looked at monthly year-over-year changes in the S&P 500’s prices and earnings since 1872 using Shiller’s data. The correlation between the two has been just 0.21, which is to say not meaningful at all. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)

In fact, it can take a long time for stock prices and earnings to sync up. The correlation between 10-year changes in prices and earnings jumps to 0.49, and the correlation over 20 and 30 years rises to 0.62 and 0.82, respectively.

So it’s not unusual for stocks to flounder even as companies post record profits.

There’s also little evidence that those profits are likely to keep stocks from sinking, as Wall Street analysts suggest. The following chart shows year-over-year changes in the S&P 500’s prices and earnings from 1961 to 1990, a volatile period that experienced multiple booms and busts. As the numbers indicate, declines in the stock market most often preceded declines in earnings rather than the other way around, which meant that in many cases stock prices fell even as earnings continued to grow.

Those three decades are consistent with the larger data. The following charts show the other three-decade periods from 1872 to 2017. They, too, show that healthy fundamentals don’t reliably signal what stock prices will do. Instead, stock prices seem to anticipate how the fundamentals will fare.  

That doesn’t mean, of course, that lower earnings always follow declining stock prices. As economist Paul Samuelson is reputed to have quipped, “The stock market has forecast nine of the last five recessions.”

Still, prices seem to pack more information than earnings, which should comfort investors, at least for now. The correlation between rolling one-year price changes and one-year volatility -- as measured by annualized standard deviation -- for the S&P 500 has been a negative 0.3 since 1928. In other words, stock prices tend to decline when volatility spikes, but that result is far from reliable, and higher volatility hasn’t yet translated into meaningfully lower stock prices.

But keep an eye on those prices. If they tumble, the fundamentals may not be as solid as they seem.    

©2018 Bloomberg L.P.

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