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.
tradersnarrative 
Getting back to inflation, an acceleration of inflation (increase in rate of price change) is negative for stock prices, so I think Russell is wrong in this analysis. In the short term, when inflation flares, stock returns usually take a hit. The simple reason: since one model of a stock price is the discounted present value of future earnings, when inflation spikes, so does the discount rate. In bond terms, stocks are a long-durated asset, so they are sensitive to that rate. That rate is subjective, so I’m willing to say that ‘animal spirits’ manifest in the discount rate that market participants apply in their pricing decisions.
TopTick, your thoughts ring true…
The last example of raging inflating was the period of 1972 to 1981…
It was the decade when the Dow Jones stood still…
Oops — forgot to finish the thought. Over the long term, however, Russell is right. At such time as a pricing equilibrium is regained (the rate of price change is steady and expectations for price changes become less volatile), stocks will reflect the increase in general prices, perhaps more so for levered corporations. This works if you use either an earnings-based model or a balance sheet model for valuing stocks.
You’re welcome Babak, and thank you for writing one of the best investment blogs on the net.
As always your articles are my first and most illuminating weekend reads. My gut tells me that in an environment where consumers have no expansion of purchasing power, so producers have little pricing power, and much of the rise in GNP is just depletion of savings by inflation in commodity-related costs and increases in debt service burdens, even if inflation continues to increase won’t that just squeeze margins, and, if so, won’t that harm earnings? It certainly won’t help strapped borrowers or result in vigorous wage inflation. Beyond that, I note that the CAPE index (Shiller trailing PE versus 10 year average inflation adjusted trailing earnings) is now the fourth highest in history; per the excellent article by Mark Hulbert in a February 4 edition of Barrons: “An even more alarming comparison comes when focusing on those prior occasions when the CAPE was as high as it is currently. Over the last 100 years, there have been only three other occasions when the CAPE was that high: In the late 1920s (right before the 1929 stock market crash), in the mid-1960s (prior to the 16-year period in which the Dow went nowhere in nominal terms and was decimated in inflation-adjusted terms), and the late 1990s (just prior to the popping of the internet bubble).”
Another item that makes me wonder is the sharp selloff in previously loved interest rate universe. The rise in rates is not bullish for stocks or the economy, although historically stocks keep rising even as rates do in a normal economic growth cycle. The sentiment on debt is getting pretty negative. There were 0% bulls among muni bond analysts for a few weeks in a row before the related indices stabilized according to an article by Randall Forsythe; there are very few bulls on Treasury bonds. Perhaps the risk trade in stocks and commodities will come off while long rates retreat a bit, or at least stop rising.
“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 certainly agree with you that sentiment or animal spirits plays a huge role in the market. The idea that the market is a rational embodiment of the fundamentals is a joke.
But your charts by no means show that the fundamentals don’t play any role. The earnings and dividend component appear to be meaningful along with P/E expansion and decline.
I think it’s important to analyze all the components of market return – fundamental, macro, technical, sentiment – to gain as complete a picture as possible.
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