A Fundamental Lesson For The Technically Minded

DO FUNDAMENTALS REALLY MATTER?
An article on the Wall Street Rant blog titled "Is This Bull Market Fundamentally Driven?" sought to help answer this question. "Fundamentally driven bull markets should rely more on cyclically adjusted earnings growth and less on investors' willingness to pay ever increasing multiples on those earnings," the author posited.

But do they? To explore this question in detail, I used the cyclically adjusted price/earnings (P/E) ratio data from Robert Shiller's website. He separated out bull markets that experienced at least 100% gains without a 20% correction between 1930 and the present and then ordered these markets from the most strongly earnings-driven to the weakest using the ratio of price gains divided by the expansion in the P/E multiples. Bulls showing the smallest P/E expansions (that is, those that enjoyed the greatest earnings growth) were considered the most fundamentally driven. His results are shown in the table in Figure 1.

FIGURE 1: BULL MARKET RANKINGS BASED ON STOCK PRICE CHANGE DIVIDED BY P/E EXPANSION. Bull markets with the highest bull fundamental ratios were considered fundamentally stronger, since stock price increases were accompanied by comparable earnings growth versus markets in which the stock prices greatly exceeded earnings growth.

Compare the 1974-80 bull with the one from 2002-07. The first experienced a P/E expansion of 2.2 versus an expansion of 7.8 for the second. In the ensuing corrections, the 1981 recession saw stock prices fall by 27% compared to a drop of more than double (57%) from 2007-09.

CHARTING THE RESULTS
For the sake of clarity, the period from 1960 to present was charted using Robert Shiller's monthly data. The chart in Figure 2 compares the S&P 500 to earnings. It shows that there is a link, albeit a loose one, between earnings and stock price. At times, like at the end of the 2001-02 recession and end of the 2003-07 bull market, earnings led. At other times, such as the peak in 2001 and bear market trough in 2003, earnings moved with stock price. Investor sentiment or some other factor appeared to determine whether stock prices followed or moved coincidentally with earnings.

FIGURE 2: MONTHLY DATA OF THE S&P 500 INDEX (LEFT-HAND SIDE) VERSUS SPX EARNINGS (RIGHT-HAND SIDE). At the end of the 2001-02 recession and end of the 2003-07 bull market, earnings led. At other times, such as the peak in 2001 and bear market trough in 2003, earnings moved with stock price.

FIGURE 3: MONTHLY DATA FOR THE S&P 500 INDEX WITH THE RELATIVE STRENGTH OF SPX EARNINGS (EARNINGS DIVIDED BY THE SPX). Earnings outperformed stock price more frequently from 1960-80 than later when earnings experienced a "bear market," consistently falling relative to price. Recessions are shown by the gray vertical bars.

During the 1982-2000 bull market, investors were more optimistic about the future of stocks -- earnings appeared to matter less. Earnings grew relative to stock prices during the 1987 bear market and more modestly from 1992-95. But other than brief periods in 2001-02 and 2008-09, stock prices appreciated well ahead of earnings for most of this period. But this euphoria came at a cost.

What is evident from Figure 3 is that the "irrational exuberance" in the 1990s caused stock prices to rise more quickly than earnings, an emotion for which investors paid in 2001-02 with a correction of nearly 50%. Evidence suggests that investors did not appear to have learned their lesson in the 2003-07 bull market. It was associated with an even greater disconnect in which stock prices were bid up well above earnings followed by an even more severe bear market drop.

What should concern traders and investors is that the 2009 bull market has so far demonstrated weaker fundamental growth, as evidenced by P/E expansion of 11.1 (thus far). If the data in Figure 1 proves a reliable guide, this puts us on track for a 50%+ correction when the euphoria finally subsides. This view is further substantiated by the 1935-37 bull, which experienced levels of government stimulus similar to what we have had recently. Stock prices in the late 1930s were pushed up to unsustainable levels and a very painful correction in excess of 50% followed.

A second lesson is that fundamentals appear to be less important over the short term. Stock prices often move higher due to investor enthusiasm and hope than due to relative earnings -- and this trend has been going on for decades.

But perhaps the biggest lesson of all is that although it may be possible to ignore earnings fundamentals for months or even years, the more out of whack stock prices become relative to earnings, the more painful and protracted the aftermath. And this is a lesson that investors all too quickly tend to forget.

SUGGESTED READING

• Short, Doug [2013]. "Is This Bull Market Fundamentally Driven?" http://advisorperspectives.com/dshort/commentaries/Is-Bull-Market-Fundamentally-Driven.php
• Robert Shiller's Online Data Link http://www.econ.yale.edu/~shiller/data.htm

Charts & Data: www.wallstreetrant.com, http://www.econ.yale.edu/~shiller/data.htm