Why do earnings rise, even as they slide?

by John Manley, CFA, Wells Fargo Asset Management

Before I try to explain this rather enigmatic title, I have to restate the rules by which we are playing. From my point of view:

• Three things drive stocks up or down: valuations, the Fed, and earnings expectations
• Valuations typically only matter when they are extremely high or low

Today, S&P 500 Index valuations are pretty much near their 20-year mean and median on forward-consensus earnings expectations. They are in the middle and therefore of very little interest to me. I think the Federal Reserve (Fed) is usually the most important factor because from time to time the Fed will either push money at the economy (to stimulate) or pull money from the economy (to slow it). That money passes through the capital markets and tends to push them higher or lower. Again, I think this will be OK but not great. There seem to be signs of improving growth. I don’t think the Fed will tighten, but its stimulus measures should soon be diminishing (think of easing back on the gas but not being anywhere near hitting the brakes). I would call my expectations of the Fed “benign,” which I suppose is better than not.

So we are left with earnings—specifically, earnings expectations. In this post, you’ll see two graphs that show a 20-year history of forward-consensus earnings expectations for the S&P 500 Index (composite) and the S&P MidCap 400 Index superimposed on the history of calendar-year expectations for both. The main point is that forward expectations seem to be rising after a two-year hiatus. This may be more obvious for the mid caps than the large caps, but it seems to be happening to both.

The second point is that forward numbers have generally tended to rise over the past two decades, even as calendar-year expectations tended to drift lower. The reader should note that expectations for calendar 2012, 2013, and 2014 earnings drifted lower over time, even as the stock market (and forward expectations) moved higher. They were pretty good years for investors. Big downdrafts in expectations (for example, in 2008) tend not to be good price-wise, but a little deterioration doesn’t seem to hurt anything. I think a certain deterioration in annual numbers is normal and not unhealthy.

This is due to the enormous difficulty in projecting earnings. Current-year projections are derived for forecasts of things like sales (pricing and volume) and margins. The analysts usually receive guidance from the company from which they take no, some, or many grains of salt. To a degree, there are usually inherent assumptions that things will work according to plan. However, there’s also usually a degree of friction on the way from plan to achievement. The following year’s expectations are usually even harder to do because they tend to be a function of the rate of change in fundamentals from this year (which we don’t yet know). Therefore, analysts usually use earnings power expectations for the following year (what if everything went as we hoped?). The Street generally knows that these are shots in the dark and tends to be forgiving as reality closes in on them.

Investors may want to stay on the lookout for forward earnings expectations. They usually have risen in the past and seem to have begun rising again. I’m not worried too much about the annual expectations. My own expectation is that the forward numbers will drive markets to overvaluations before the bull market is over.