Does Lower Earnings Growth Mean Lower Stock Prices?

Lower Earnings Growth

With the consensus view being that earnings growth will be declining, this may cause us to be concerned that the value of our stocks may be going down. Will this happen?

People who pay a fair bit of attention to the news about the stock market and the stocks that they may be holding are pretty aware that the stock market does watch earnings reports and earnings forecasts pretty closely.

There’s no question that the media does focus on these things quite a bit, and when these reports come out, they do affect stock prices pretty clearly. Reports that disappoint see the companies’ stock quickly punished, and those that exceed expectations are often rewarded with boosts in their stock price.

These things would therefore seem to be pretty important indeed, and although the impact upon a stock’s price is felt immediately, that same day, as all news is, this can also linger for quite a while and keep a stock in the doldrums long past earnings report day or keep a stock valued higher for quite a while as well.

We might think that, due to the nature of markets, once the information has been disseminated and digested than that would be the end of it and we would then wait for the next piece of news, the next quarter’s earnings report or other news that may materially affect the company or its stock.

What we need to be aware of is that this reaction occurs due to whether or not expectations are met or not, not so much because a company’s growth is speeding up or slowing down. It’s not that these other things don’t matter, but the reaction to earnings reports just represent the extent that we are surprised or not, either now or within a company’s forecasts of the future.

The reaction itself may cause an ongoing reaction though, which we call momentum, and it’s not hard to see how this might happen on both sides. Bad news comes, the price of the stock gets devalued, and then this devaluation can cause more people to want to get out of the stock or not want to pay as much for it as they did before if they are buying it, and this momentum is what is behind the trends that we see in stock prices.

Good news can function the same way, and now instead of seeing a stock’s price drop, we’re seeing it go up, and together with the good news that we have heard, we decide to jump on board with it or hang on to it if we were considering selling it. If we do sell, we now want an even higher price due to this momentum and that also causes the price to rise.

Even with the effects of this momentum in place, we tend to look toward these earnings reports and hold them responsible for the moves, and to the extent that the news did influence them, we would at least in a sense be right, where good news is good and bad news is bad for stock prices generally.

Stock Prices Are Actually Determined Subjectively

We tend to make a leap here though and think that stock prices themselves are driven by earnings directly, and this is where we get lost. There is a view out there that is held by many that a stock’s price measures earnings, and this is where the idea of value investing arises from, and people will compare a stock’s price to its earnings and determine whether it is overvalued, undervalued, or valued correctly.

While earnings matter, earnings themselves do not drive stock prices, although people’s perceptions of them do. We see companies who are losing money have stocks that are valued positively, meaning that you pay money to own it rather than their paying you, and if the valuation model was correct, they should actually pay us to own it according to the standard model of valuation at least. This would involve stocks which have positive earnings being valued as a multiple of their earnings and losing companies paying us a multiple of their losses for the year to own their stock during these times.

This might sound ridiculous, and it is, but this does follow from this model, although we instead just close our eyes to these situations or take a more correct view that stock prices involve more than a company’s current earnings or projected ones for the current year, with losing companies anyway, but with the profitable ones we go back to our valuation model.

All stocks actually work that way and the valuation model is a broken one with both profitable and unprofitable companies because we look at the future with both. To look at a company’s current earnings picture and think that this could explain its stock price is far too narrow of a view period.

We could call this broader view of a stock’s value our future expectations, and these expectations are influenced by a number of things such as expected future business performance which can extend pretty far into the future, expectations of the growth of the market in general over various periods of time, and expectations about momentum, which plays a significant role in the equation as well.

It’s actually all about momentum, and these other factors are among those that influence it. We can take the sum total of all objective factors that may influence a stock’s price, and this by itself doesn’t influence anything, with the extent of the effect contingent upon the market’s perception of it.

Last Friday’s jobs report was a good example of this, as we would normally think that this would be bullish news. The market sold off after hearing it and did so in a manner that left no question that this was seen as bad news, with those who perceived this as reducing the chance for a half-point rate cut by the Fed at the end of this month heading for the exits.

The market pricing in the potential for a half-point rate cut wasn’t even aligned with reality, as they have already told us that this won’t be happening, and even the sole member who voted for a rate cut last time has said that a half-point would be too much. Still though, the market has priced in this big of a cut to some degree, based upon hope alone, and hope does move stock prices, whether or not the hope is realistic or even based upon reality at all.

We ended up recovering from that when the stampede toward the exits wound down and others stepped in and pushed us back up almost all of the way, and this all actually makes sense. The people who drove the price back up had a more positive perception of things and also saw this as an opportunity for a better bargain than what could have been had the day before.

The point here is that it is perceptions and not hard numbers that drive stock prices, and it’s not even that perceptions influence it a bit, or even substantially, it’s the whole deal actually. We have the actual numbers and we have actual stock prices and perception is the intermediary here that controls how we interpret the world, whether that be earnings reports or anything else that may be considered to be of any importance to stock prices.

This is a very important lesson to learn and perhaps the most basic one when we’re trying to understand how stock prices move, and not getting this will lead to all sorts of confusion whenever our models that are based upon other things cannot explain price movements.

It’s All About What the Mood is Like

How we interpret earnings reports and forecasts is a relative thing, and we can boil this down to things that make us happier or unhappier. Missing earnings forecasts is perceived as an unhappy event and it is this perception of unhappiness that drives stock prices down, nothing more and nothing less.

If, therefore, we are expecting lower earnings growth in the upcoming round of quarterly earnings reports, or lower forecasts for the next quarter or the coming year, and that’s what we get, there is actually no change involved. It is like we have been comfortable with a company seeing its earnings decline from, say, 80 cents a share to 70 cents, and if we end up with 70 cents, we’re happy enough, just as happy as we were the day before. If it comes in at 75 cents, earnings have gone down, but we’re happier and we generally will put the price of the stock up in spite of earnings declining.

Stock prices do measure changes in perceptions, and this is what we need to focus on. Since this news isn’t really that well known and we do get surprises, we can’t always plan for these things, but at the same time we can’t just say that earnings growth declining will put down stock prices because that might be what we are expecting and our attitude can still remain positive in the face of this.

This is, once again, just part of the picture and there are a lot of other things that determine stock prices besides earnings growth. Earnings growth itself is focused a lot more on the current quarter or the next one as people invest in stocks and are concerned about time periods longer than this.

Those who feel that stock prices are driven by current earnings directly and feel that declining growth rates should put the price of stocks down miss the point that positive growth should drive stock prices up and not down. At worst, this would reduce the growth in a stock’s price if this really was what moved it, where we may go from seeing our stock go up 5% instead of 10% in a year for instance, but this involves the stock going up, not down.

If we look at this objectively, it actually would be ridiculous to think that a reduction in earnings growth could put stock prices down and do anything more than reduce the growth in the stock price proportionately, but for some reason a lot of people don’t experience this revelation and continue to think that this means trouble for stock prices.

This situation isn’t determined objectively so much as it is subjectively though, and we certainly can see stocks decline when earnings growth declines, and even when it increases, because once again this is only one influencer among many.

It does not make sense though to assert that seeing earnings growth slowing down or economic growth slow down for that matter and then assume that stocks will go down in turn. Perhaps they will, but it won’t be from this, because this contributes to a stock being more valuable than before if we are using the valuation model.

Things are humming along quite nicely right now in fact, in spite of some people being concerned about the coming loss of earnings growth, and while this in itself might limit how much stocks grow, all things being equal, this will still make stocks more and not less valuable from a valuation standpoint, if that’s how we like to measure these things.

It’s still actually all about perceptions though, and the perception right now remains positive in spite of some people doing a little too much hoping about rate cuts, and it is likely that more people will end up being disappointed as the situation unfolds and they don’t get what they hoped for.

However, there is also the other side to this, and if others are willing to step up and take up the slack like they did during the second half of last Friday’s trading, we will be fine.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.