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Corporate Profits Will Be Up Next Year

Must Stocks Be?

By William Hester, CFA
November 2003

Corporate earnings and stock prices both fell in 2001 and 2002. This year profits are up, and stock prices are too. Seems like a predictable pattern: profits rise or fall and stock prices follow. But it isn't. In fact, earnings and stock prices seldom move in lockstep.

With many investors making the link between expected earnings growth and higher stock prices, the topic is worth exploring. "The market is fairly valued, and will respond in the future to the level of earnings growth generated by the recovery," a professional investor told Barron's in its recent money manager poll, echoing the voice of many stock market pundits.

Profits are certainly on the upswing. Reported earnings of the S&P 500 companies could jump 61 percent this year, and another 24 percent next year, according to Standard and Poor's.

Lost in the euphoria, though, is that most of the explosive growth is simply a recovery of lost ground. Though the 2001 economic recession was mild, corporate profits were pummeled. Reported earnings for the S&P 500 companies were $53.73 a share in 2000. In 2001 they fell to $28.52 and then to $26.74 in 2002. This was one of the worst drops on record for corporate earnings.

A pop in profits is typical following a recession. Companies benefited similarly once the early 1990's recovery moved into gear. Earnings of the S&P 500 companies rose by 33 percent in 1994 and 28 percent in 1995.

But rising aggregate earnings do not guarantee higher stock markets. In 1973 profits rose 25 percent and by another 21 percent in 1974. As profits boomed, stock prices slid nearly in half.

Equity prices can rally when earnings take a hit, too. The very next year, in 1975, stocks rose 37 percent, one of the highest one-year total returns on record, and earnings fell 18 percent. And in four of the five years from 1982 through 1986 corporate profits fell while stock prices rose strongly.

In fact, since 1950 stock prices and earnings have moved in opposite directions about 40 percent of the time. Looking only at only the years where profits rose, prices fell 25 percent of the time.

The correlation between earnings and stock prices is surprisingly low: 0.01 since 1950. This is largely due to the dramatically different directions earnings and stock returns took in the early 1970's and 1980's. Surprisingly, the low correlations can't be explained by assuming that stock markets look into the following year. Lagging the earnings data, that is, matching the change in stock prices one year with the change in profits the next, doesn't improve the results measurably.

Corporate Earnings and its Co-stars

Earnings growth certainly supports rising stock prices over time. Any long-term graph of profits and prices shows this. But over a period as short as a year, other factors can frequently overpower the direction of earnings. In the early 1980's investors ignored punk profits and focused on the dramatic decline in interest rates. Accelerating inflation and a spike in oil prices helped kick off the 1973-74 bear market, even in the face of strong earnings growth.

These unexpected shocks to the economy can shift investor risk preferences. Good news welcomes more risk taking and higher stock prices. Bad news can sink them. Falling risk tolerances and high valuations make an especially painful pair, as the pricking of the technology bubble in 2000 and the correction of equity markets during the 1998 Asian crises show.

There are plenty of potential hazards currently waiting in the wings - the record current account deficit, a weaker dollar, or potentially higher interest rates. But predicting if and exactly when they'll become a factor in investors' eyes is a forecast few will get right.

So prices might rise with profits next year; they've done so 75 percent of the time*. Just don't rely on the belief that it's in the hand.

* This statistic may not be as impressive as it seems. Stock prices have historically advanced about 70 percent of the time anyway, and as noted earlier, those movements don't closely match the rate of earnings growth over the short-term.


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