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Ignore the Beats and Misses For Market Predictions

Follow price action, not earnings, in the short-run

By Charlie Bilello


We’re right in the heart of earnings season again with everyone hanging on each release as if it were the most important indicator for market. We all know that earnings are the driver of equity returns over the long-run, but how important are they in the short-run? And more importantly, do earnings lead equity prices or do equity prices lead earnings?

The answer to these questions may surprise you given the incessant media coverage of “beats” and “misses.” Let’s take a look back at the last few years to see how good of a predictor earnings were for the broad market.

In 2011, the S&P 500 (SPY) finished flat on the year while earnings increased 15% over the prior year. Next, in 2012, earnings were flat but the S&P 500 advanced 13%. Last year, earnings advanced 10% while the S&P 500 gained nearly 30% on the year.

Going back in history, you’ll find a similar results, with year-over-year earnings having a very low correlation of .17 (since 1900) with year-over-year changes in the S&P 500. But if earnings aren’t driving short-term returns, what is? Investor behavior and sentiment are much more important factors, as they directly influence the multiple people are willing to pay for a given level of earnings.

When sentiment is positive and momentum is strong, people are willing to pay significantly higher multiples for the same level of earnings. We saw that last year as the S&P’s return far outpaced earnings growth. Will that be the case again this year or will earnings catch up with last year’s gains? I have no idea and anyone who says they do is being disingenuous.

Which brings us to the second question posed above: do earnings lead equity prices or do equity prices lead earnings? In most cycles, price moves first, then you learn about the positive or negative earnings backdrop. During the last bear market, we didn’t learn about declining earnings until the first quarter of 2008. By that point, the S&P 500 had already declined over 20% from its October 2007 peak. Conversely, coming out of the last recession, we didn’t learn about improving earnings until the first quarter of 2010. By that point, the S&P 500 had advanced over 70% from its March 2009 low.

Therefore, like every other earnings season, I will be more focused on price action before and after the release than the release itself. The big news yesterday last week was the weak holiday sales report from Best Buy (BBY), which sent the stock sharply lower by nearly 30%. If you look at the chart below, though, you’ll notice that the stock price was trending lower well in advance of this report. The market action was already telling you that something was not right at the company, then the negative news came.

Following a report, the best tells for the market tend to be a positive reaction to a “poor” report or a negative reaction to a “strong” report. It is for this reason that I like to use Amazon (AMZN) as a barometer for overall market sentiment on earnings.

For over three years now, Amazon has been reporting year-over-year declines in its earnings. At the same time, though, its stock price continues to hit new all-time highs (see chart below). What this is telling you is that market participants don’t care about current earnings and are assigning an increasingly higher multiple on the company with the expectation that future earnings will be strong.

If market participants don’t care about earnings for one its largest companies, then why should we expect there to be a relationship in the short-run between earnings and the market in general? Of course, this will not go on forever as earnings multiples are mean reverting and sentiment is constantly changing.

One day in the future, Amazon will have to show a profit or its shareholders will vote with their feet. As for when that day will be, I’ll continue to focus on the price action following earnings rather than the earnings themselves. The next Amazon report is on the 30th of January. If you’re going to follow one report this season, this is the one to follow.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.


Article printed from InvestorPlace Media, https://investorplace.com/2014/01/ignore-beats-misses-market-predictions/.

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