Yesterday I wrote about the sudden bullishness emanating from Richard Russell. His thinking was that when price inflation does finally arrive it will also propel the earnings of US corporations. I don’t question the interconnectedness of inflation and earnings.
My skepticism was with the implied assumption that earnings have a direct link to actual stock market returns. In response to my call for help, reader Mike C. referred to a report written by Crestmont Research on the components of 10 year stock market returns:
Source: Crestmont Research
I had written that P/E contraction and expansion was much more important to total returns than earnings. The data in the above chart bears this out.
During the two major secular bull markets (1950-1960’s and 1980-1990’s) as earnings and dividend contributions to total returns receded, it was P/E expansion that helped to keep the party going. Until it was crushed in the ensuing bear market and fell below zero.
As well, you can see two inflationary periods: post-Second World War and the 1970’s. In each one, earnings did indeed rise along with inflation – just as Richard Russell argues. However, more importantly, the implosion in P/E ratio meant that total returns were either poor or horrendous.
The chart below shows the rolling 10 year stock market returns – I used a very similar indicator to suggest in March 2009 that it was time to go long.
This is why I hardly pay attention to fundamental data such as earnings. The “E” accounts for very little in the over all scheme of things. And the little that it accounts for can be completely offset or exaggerated by the much more volatile contraction and expansion in multiples.
This is also exactly why I’m so preoccupied with the “animal spirits” or sentiment. That is, how much at any point in time we value $1 of earnings. The same earnings can be seen as less or more valuable, depending on who you ask and when you ask.
I would also recommend the newly released book by Ed Easterling of Crestmont: “Probable Outcomes: Secular Stock Market Insights“. The book was published just a few weeks ago and it is full of similar graphs offering to chart a course for the next decade in the stock market. I’m going to read it myself and offer a summary and review in the near future. It comes highly recommended by those who had advance copies (John Mauldin, Richard Sylla, Henry Kaufman Professor of the History of Financial Institutions and Markets and Harvey Rosenblum, Executive Vice President and Director of Research, Federal Reserve Bank of Dallas, etc) as well, it follows the first book Easterling wrote, Unexpected Returns: Understanding Secular Stock Market Cycles which was also well received.
Thanks again to Mike C. I continue to be humbled and impressed by the caliber of my readers.