Earnings Matter to Stock Prices

The U.S. earnings season has kicked off for the third quarter. Earnings give us extra insight into how the economy is going, but more importantly, data shows earnings are important to stock prices. 

This quarter will also show whether the U.S. earnings recession will continue or earnings will again start to grow. Today, we look at earnings, how they drive stock prices and what sectors are driving the recovery in earnings so far this year. 

Over the long term, earnings drive prices 

Looking at the data below, we see that market-wide prices and earnings track each other closely over a very long timeframe. Said another way, earnings growth drives a majority of stock returns. 

Chart 1: Market-wide earnings and prices track closely over the long term 

The fact that prices and earnings track each other closely is also why the “price-to-earnings ratio” is such a useful and simple measure of stock market valuations. 

However, there are periods where the ratio dislocates. For example, during the 70’s, prices remained below earnings for more than a decade. Yet, it may not be that stocks were “cheap” during that period. Looking at the dark grey area at the bottom of the chart shows that interest rates were also unusually high during this period (thanks to former Federal Reserve Chair Paul Volcker, who was trying to tackle inflation).  

When short-term interest rates rise, returns on bonds (and stocks) need to increase to remain competitive – the market does that by making bonds (and stocks) “cheaper” – so that capital gains will be larger until bonds mature, and dividend or earnings yields on stocks will be higher, adding to returns while investors hold the asset. 

We also see that periods of recessions (shown as light grey vertical bars) tend to see short-term drops in company earnings - as the economy and revenues shrink. However, stock prices don’t typically fall as much. That confirms that stocks represent a company’s long-term earnings – so stock prices don’t drop as much as the current earnings cycle. 

That’s also consistent with finance theory – that a stock represents a share in the future income stream of a company (which, in theory, can operate in perpetuity).  

That, in turn, is why “discounted cash flow” (or DCF) models, where you subtract costs of capital from future expected earnings, are frequently used to value companies. In short, if you know what the future earnings of a company will be, you should be able to work out what the future stock price should be – and whether that means the stock is “rich” or “cheap” at current prices. 

All of this is to say – earnings are important! 

U.S. companies might come out of their earnings recession 

Looking at the current quarter reporting, analysts currently estimate S&P 500 earnings will decline 0.7% YoY. If that holds, it will extend the “earnings recession” with a fourth straight quarter of negative earnings growth. 

Chart 2: Earnings are expected to turn positive this quarter or next 

However, research shows U.S. companies tend to manage expectations down – then beat expectations. According to FactSet, the S&P 500’s actual earnings growth rate has exceeded the estimated earnings growth rate in 37 of the past 40 quarters. In fact, we typically see around 75% of companies beating expectations each quarter. So, there’s a good chance that, as more companies report, we could see earnings growth move back into positive territory. If that happens, the earnings recession will be over.  

In any case, starting next quarter, earnings are expected to ramp up, averaging +10% YoY over the next year. And as we saw in Chart 1, that should be supportive for stock valuations. 

Most sectors are already growing earnings 

Taking a closer look at third-quarter earnings by sector, we can see that most of the Consumer names are doing better already.  

Communication Services (Netflix, Disney, Activision) are on pace for 30+% YoY growth, while Consumer Discretionary (Amazon, Travel, Restaurants) is expected to see 20+% YoY growth. 

Chart 3: Year on Year earnings change shows many sectors growing 

This confirms what economic data is telling us – consumer spending continues to defy forecasts of fatigue or costs of higher rates. That was confirmed by this week’s retail sales data, where consumer spending rose 0.7% from August (chart below, blue line) – more than double consensus expectations – and outpacing inflation. 

The bulk of that growth has come from online shopping, restaurants, and entertainment (and gasoline, since prices rose from Q2 to Q3), overlapping with Communication Services and Consumer Discretionary. Although durable goods spending, like furniture, shrank. 

Chart 4: Recovery is driven by continued consumer strength 

There are also good reasons for sectors with negative returns. A number of Health Care companies are coming off highs reached during Covid now that fewer people are taking boosters and testing. Energy prices have fallen as the shortages caused by the war in Ukraine have faded, with oil prices down 12% YoY in Q3 and natural gas prices down nearly 70% YoY. Meanwhile, Materials companies mirror the manufacturing recession, although it seems that industrial production data has recently started to regain momentum. 

Markets may have already priced in some of the earnings growth 

In fact, the stock market this year was tracking the historic returns of bear markets where no recession followed (a soft landing, shown by the blue line below). Although the sell-off of the past two weeks seems to show the market is worried about the soft-landing scenario (the black line has fallen out of the blue zone). That’s because the sudden climb in 10-year interest rates to almost 5% might end up hurting the economy and company profits. Some are saying it might even mean the Fed won’t need to do another hike in short-term rates. 

Chart 5: Markets had been pricing in a soft landing until the recent increase in 10-year interest rates 

Earnings and rates are both important to stock prices 

We see here that earnings are important to stock valuations and that markets typically include earnings from years into the future to work out what companies should be worth today. 

That’s likely the case today, too, with the recovery in stock markets already pricing the expected recovery in earnings. That just makes it more important to see how strong the recovery in earnings ends up being. 

Michael Normyle, U.S. Economist at Nasdaq, contributed to this article.