Earnings Propaganda to Fool Investors (Again)

Earnings Propaganda to Fool Investors (Again)

Today’s Daily Reckoning seeks to bash down the false narrative permeating the press right now.

The dull and unimaginative would have you believe Aussie stocks are merely on track to muddle along over the next year — at best.

They bring up unexciting earnings projections from market analysts to justify why.

They also love to cite things like high debts and timid consumers to help carry their argument.

I’m calling bollocks on all this. I’m going to cite evidence from the US market to show you why…

How the US market fooled the many

Did you know companies in the S&P 500 index recorded six consecutive quarters of negative earnings growth over 2014-2016?

You can see that here…

Source: Financial Times

The same arguments came out for the US in 2015 and 2016, as they are now here. The intuitive response was to worry why stocks were rising if earnings were falling.

Except our intuition can lead us astray here. I actually wrote about this problem in July 2016.

Here’s what I wrote back then (talking about US stocks):

Falling earnings are a good sign of an ongoing rise in the index. It may sound insane, but this is backed up by empirical evidence.’

The S&P 500 closed at 2169 points on 26 July, 2016. It finished last week at 2443.

That’s up 12.6% since my July 2016 comment.

I’m not making any claim to being such a smart guy. I just happened to read about a dodgy link between earnings projections and the US index from a book written in 2003 by a man called Victor Niederhoffer. It’s called Practical Speculation.

When billionaire George Soros wanted to teach his son how to trade, he sent him to Niederhoffer.

Not only does Niederhoffer attack the notion of the index moving in line with earnings, he absolutely destroys the price-to-earnings (P/E) ratio as a reliable guide.

Both of these ‘indicators’ are often cited as reasons why the bull market in US markets is false…or unsustainable…or pending collapse.

This is not new — obviously. Practical Speculation was released in 2003.

So how does Niederhoffer justify this? He says there is just too much ‘uncertainty, latitude and fuzziness in the level, timing, and volatility of earnings comparisons and expectations to place undue reliance on them.

The book examined relations between earnings and market returns over 65 years.

They came to this counterintuitive conclusion:

  • If reported S&P 500 earnings rise in a year, the S&P 500 is likely to perform worse than average that year.
  • If reported earnings fall in a year, the S&P 500 is likely to perform better than average that year.

Keep in mind that Niederhoffer is talking about probabilities based off historical market action from 1937–2001.

Underlying the study and the market today is the fact that there’s zero consistency in how earnings are accounted for — or reported.

Companies have every incentive to employ armies of accountants and lawyers to obscure what’s really happening when they release information pertaining to performance.

Niederhoffer calls earnings, and any conclusion drawn from them about the market, ‘propaganda’ more than anything else.

It’s important to note that when Niederhoffer is talking about this negative correlation between earnings and the index return, he’s talking about the market as a whole ­­— not individual stocks.

That’s because the market is influenced strongly through other factors like interest rate moves, buybacks, tax changes and the Fed.

The delicately poised ‘wedge’ in the Aussie market

The latest earnings report in the US shows profit growth of 11%. In hindsight, we can see the index was rising because it was pricing in this outcome.

Let’s bring it back to Australia. The fact that earnings projections are low doesn’t necessarily mean that Aussie stocks can’t rise from here.

The index will rise before any positive earnings lift becomes obvious. The stock market is always pricing in what’s coming up, six to nine months in advance.

That’s not to say the index will rise, of course. There are no guarantees here.

And right now, the Aussie market is delicately poised. It’s stuck in what technical analysts call a wedge. It’s threatened to break to the upside a few times, but keeps being dragged back.

6000 points looks like a key point. I mentioned the other week that I was at a Livewire investing conference recently. One of the fund managers argued the market would be ‘off to the races’ once 6000 points was breached.

My expectation is the same. But we’re not there yet. I get the feeling everyone is waiting for the market to break decisively in one direction or another, and go with either way the major trend runs.

If the market does really move to the upside, don’t let dull earnings projections fool you into thinking it’s a rally that can’t last.

Best wishes,

Callum Newman,
Editor, The Daily Reckoning Australia