The market is becoming less discerning

I don’t know about you but to me, it feels like over the last 20 years or so, the stock market has become less and less discerning about corporate earnings. Whether a company has good or bad earnings matters less and less for share prices and instead it is the overall market sentiment that drives a larger chunk of equity returns.

Apparently, that gut feeling was not too far off, at least if you believe this study of US companies. What the authors did was predict share price returns for all companies in the US outside the financials sector based on the historic relationship between earnings growth and share price return. To do this, they used a rolling 20-year window to fit a simple regression model that linked share price returns over the 12 months following earnings releases. Across thousands of US companies, this simple approach to forecast returns based on a time series of earnings explained some 5% to 6% of the variation in share price returns. If that sounds low, you might want to read this before you go on. Don’t worry, I’ll wait…

…all done? Good.

In a second step, the authors of the study tried to predict the return of stocks based on the average relationship between earnings and share price returns over the last 20 years. Instead of running a regression analysis for each stock individually, they simply ran one for the average earnings across all stocks and the average returns for all stocks. The share of variation in share price returns explained by this systematic earnings trend across the market used to be negative (i.e. worse than chance), but over the last 15 years or so it has become the dominant force of share price returns, now explaining some 20% of the variation in share prices across companies.

Share of equity returns explained by earnings

Source: Sadka et al. (2022)

The authors speculate that this effect of dominant systematic earnings is driven by intangible assets and the mark-to-market of intangibles and other assets on the balance sheet as accounting rules have increasingly embraced a mark-to-market approach. My guess is that the rise of passive investments also has something to do with it. But whatever the reason, the trend is clear: Individual company earnings matter less and less compared to the overall market trend and how investors perceive this overall market trend.