by Bob Stokes
Updated: July 28, 2017
The notion that "earnings drive stock prices" powers a lot of research on Wall Street. See a chart that torches this assumption.
[Editor's Note: The text version of the story is below.]
About a third of S&P companies reported earnings this week.
So, it's an appropos time to reiterate that "earnings drive stock prices" is an assumption that powers a lot of research on Wall Street.
And, for as long as we can remember, headlines from the mainstream financial media have reflected that assumption (July 14, CNBC):
S&P 500 closes at record, topping June high, on bets for a strong earnings season
But, you might want to question the widely held belief that there's a reliable correlation between earnings and stock prices.
You see, financial history shows that stock prices can trend in the opposite direction of expectations based on earnings. Review this chart and commentary from the February 2010 Elliott Wave Theorist:
...in 1973-1974, earnings per share for S&P 500 companies soared for six quarters in a row, during which time the S&P suffered its largest decline since 1937-1942. This is not a small departure from the expected relationship; it is a history-making departure. ... Moreover, the S&P bottomed in early October 1974, and earnings per share then turned down for twelve straight months, just as the S&P turned up!
You might be tempted to say: "Well, that's just one time period when earnings and stock prices went in opposite directions."
Well, even if this were the only instance, keep this comment in mind from Robert Prechter's new book, The Socionomic Theory of Finance:
In refuting a theory [in this case, the theory that earnings drive stock prices], statistical rigor is unnecessary. If someone says, "All leaves are green," all one need do is find a red one to refute the claim.
Yet, despite the evidence, earnings as the "driver" of stock prices is still considered gospel truth.
An October 5, 2007 Wall Street Journal article said:
All three major indexes rallied this week, lifted by hopes that the worst of the credit crisis is over and that the economy is still strong. Next week, corporate earnings season kicks off -- will profits substantiate the market's gains?
The Dow Industrials peaked four days later.
If earnings -- or the economy -- do not govern stock prices, what does?
In a sentence: Market trends are governed by patterns of investor psychology.Our analysis suggests that a major shift in investor psychology is at hand.