As usual, Alcoa kicked off the quarterly earnings ritual. Corporate profits will be on display for weeks to come, but are earnings a leading or lagging indicator? Here’s the long-term effect of earnings on stocks and the one pattern worth watching right now.
‘Tis the season to get jolly about earnings. The quarterly earnings ritual pays a visit every quarter and captures the interest of Wall Street and Main Street alike.
How much do corporate earnings affect stocks? Are earnings a leading stock market indicator?
A chart says more than a thousand words and the one below plots the S&P 500 against US corporate profits measured in nominal dollars and corporate net profits as a percentage of GDP.
Fundamental analysts use earnings per share (EPS) and P/E ratios to figure out where a stock should be trading. By extension the same process is applied to broader indexes, like the S&P 500 or Dow Jones.
As evidenced by the chart, there has been an obvious correlation between profits and stock prices (at least since the late 1990s), but its not as snug as some analysts make it seem.
Corporate profits rolled over several quarters before the stock market peaked in 2000 and 2007. In hindsight, one might extrapolate that corporate profits are a leading indicator.
However, the problem is that profits aren’t known until well after the fact. Earnings are released after the fact and the Bureau of Economic Analysis (BEA) reports quarterly profits with a 3-month time lag.
In addition, who knows if a one-quarter decline is just a one-quarter chink in the chain leading to higher prices or the beginning of the next recession?
If you’re inclined to wait for a second quarter, you’re already talking about a 9-month time lag. The long-term earnings picture provides little direction for short-term investment decisions.
Here’s a short-term first quarter earnings pattern that’s worth watching. Solid earnings, even record earnings, have been followed by weak stock performance in April/May.