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Yearnings for Earnings

April 6, 2015

Jim McDonald Image/Headshot Jim McDonald
Chief Investment Strategist
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U.S. corporate earnings are in the middle of a “recession” – but how big of a problem is that?

Stock market investors take it as gospel that stocks follow earnings, and there is considerable effort expended by brokerage firms and the financial press to analyze quarterly earnings reports from public companies. However, our experience over the years has been that this effort isn’t always fruitful at the macro level – the near-term performance of earnings seems to have little forecasting value over the next year’s market returns. While its predictive value improves modestly when you extend your horizon to five years, the long-term importance of earnings to stock prices remains undisputed. The greater than 50% drop in energy prices over the last nine months has led to a slashing of energy company earnings estimates, leading to an “earnings recession” in the United States (defined as two or more quarters of declining earnings). How unusual is this – and what does it mean for stock prices? Also, what is the outlook for earnings over the next year or two? Will growth be sufficient to keep investors’ interest in stocks? Our research indicates that earnings recessions that occur outside of economic recessions (which have been just under 40% of the occurrences over the last 80 years) have led to increased volatility but continued positive stock market returns.

Our analysis of the relationship between earnings growth and stock prices shows a consistent message globally – there is no discernable relationship between earnings growth and one-year stock price movement. We calculated an R-squared of 0.014 for both U.S. and World ex-U.S. equities when regressed against stock prices (we advanced stock prices by six months to capture the market discounting mechanism). This R-squared increased modestly to 0.099 when we increased the study period to five years, but even this isn’t very predictive. The bottom line: it is the interplay of many factors (such as investor sentiment, monetary policy, inflation, broader economic growth, etc.) that affects stock market returns in addition to the earnings outlook. However, this hasn’t quieted the concerns over the current “earnings recession” in the United States and the potential that this portends problems for the stock market.

We have quarterly earnings data for the U.S. market going back to 1936, so we focused our study on this region (our experience has been that investor behavior tends to be similar across most markets). We defined an earnings recession as two consecutive quarters of declining earnings. A recent article in Bloomberg News caught our eye when they stated that an earnings recession of three quarters or longer has triggered a bear market 82% of the time over the last eighty years – now that is a little worrisome! However, to better understand the phenomenon, we looked at the data from a different perspective – whether the earnings recession occurred alongside an economic recession (a “double” recession) or during a continued economic expansion. It’s our theory that the earnings shortfall in the latter case would be viewed as temporary and would therefore be of less concern to the market. Happily, the data bears this out. We determined that there have been 21 earnings recessions in the United States since 1936. As shown in Exhibit 2, the stock market reacted poorly to the “double” recessions (falling an annualized 12.8% in the six months leading up to the earnings recession) while the market looked past the other earnings recessions.

The median return in the six months ahead of an earnings recession in a continuing economic expansion was 18.3%. In our current earnings recession, the comparable figure is a positive 11% – indicating the market isn’t overly concerned we are headed into recession. Stocks actually have had strong performance during the double recessions, jumping 19.4%, as investors react to likely easier monetary policy and begin discounting an eventual economic recovery.

The nature of the economy and markets has matured over time, so we tend to put a heavier weighting on more recent experience. Since 1976, we have had three periods of falling earnings outside of a recession, although only two (1986 and 2012) lasted for two or more quarters. The third period was an earnings dip of 5% in the third quarter of 1998. Volatility in the market during these periods was elevated, with corrections of 10% or greater each time. In addition, these periods included material weakness in oil prices, with peak price declines ranging from 29% to 58% during the year. Despite these challenges, the full year stock market returns of 15% in 1986, 29% in 1998 and 16% in 2012 show that these earnings dips proved to be temporary affairs. The promise of easier monetary policy has historically provided a cushion to markets during these periods, but that cushion is currently pretty thin this cycle in the United States as the Fed has limited tools that remain unused. That meaningfully increases the criticality of a continuation of the U.S. economic expansion. As we believe the United States is in a slow – but durable – economic expansion, the historic data bolsters the case for staying the course with equities.

Turning to the outlook for earnings, we have been cutting our earnings estimates since late 2014 due to the fall in energy prices, and to a lesser extent, the strength of the U.S. dollar. Reflecting the globalization of the economy and revenue streams of publicly traded companies, the correlation of earnings between the United States and Europe has been relatively high (see Exhibit 3) in recent times. The correlation between U.S. and European earnings steadily increased during the long expansions of the ’90s and last decade. Though all U.S. domiciled, S&P 500 companies earn approximately 35% of their revenues outside the United States; while roughly 50% of European public company revenues come from outside Europe. The outlier remains Japan, where the correlation has generally been negative over the last 20 years. However, these numbers seem less convincing due to the impact of losses (i.e. negative earnings numbers on the growth computations and eventual correlation coefficients) – rendering them less meaningful.

An area of particular concern has been the impact of falling energy prices on U.S. earnings, given the boom in shale oil and gas production over the last five years. Exhibit 4 shows the relative contribution of earnings at the sector level. Energy earnings have fallen to under 5% of S&P 500 earnings (from 12% in mid-2014), and greater percentages outside the U.S. Energy earnings have fallen across the board, but more significantly in the U.S. due to the high leverage of the domestic producers.


Our forecast for S&P 500 next-twelve month’s earnings growth of 3% reflects an organic growth assumption of 7%, less an estimated $3 reduction from the strong dollar and a $5 reduction from the energy sector. We do think the negative energy impact will be offset somewhat by around $1.50 from improved consumer spending and reduced energy input costs. The impact from currency translation on stock prices is of considerable debate, but recent research from Empirical Research backs up our experience from our days doing securities analysis. Their research indicates that for more than 95% of large-cap stocks, movements in the dollar have failed to explain their performance. To summarize, investors worry about companies that may lose business from a stronger currency, but worry much less about existing international earnings that are suddenly translated into lower numbers due to an appreciating currency.

Our relatively modest expectation of earnings growth of 4% for the MSCI World ex-US disguises some fairly major differences, from Eurozone growth estimated around 15%, to Australian and UK growth of -1% and -9%, respectively. While European earnings have benefitted in some sectors from euro depreciation (such as consumer staples), other sectors have seen earnings estimates cut in line with their global peers (such as financials, consumer discretionary and industrials). Australia is suffering from a projected 30% drop in materials earnings, while the UK is being hurt by a 46% drop in energy earnings and a 23% drop in materials earnings. In the emerging markets, China’s expected growth of 5% is emblematic of the group – reflecting the overall pace of growth and the effect of maturation of their economy. Stronger growth is expected in India (up 13%) as their economy retains momentum, while the energy and materials markets are punishing Russia and Brazil (down 28% and 8%, respectively).

While the intent of this piece is to analyze the importance of – and outlook for – earnings, a final word on valuations is in order. Global equity valuations have been pushed up by the multi-year bull market, and most recently by the whiff of an economic rebound in Europe. As a reminder, our research indicates that valuations are an ineffective timing tool, (having no real proven impact on next 12-month returns) but they demonstrably impact longer term (5-year and longer) returns. The MSCI U.S. Index is trading at 20 times trailing earnings, a 20% premium to its long-term median, while the MSCI Europe Index is at a 37% premium. While Europe does have improved economic momentum, we believe the market is pricing in a bigger earnings rebound than may be justified. Japan’s multiple is probably better assessed relative to its developed market peers, as its historic valuation measures are inflated by their massive bubble. Emerging markets look attractive relative to history, but will need to regain economic momentum to be able to catalyze that valuation opportunity.

So while the broad developed markets look expensive relative to history, we remain in a central bank supported world where the relevant risk-free rates in each region are extraordinarily low. The S&P 500 dividend yield of 2% beats the 10-year yield of 1.90%, and the European and Japanese comparisons become somewhat absurd with the German 10-year at 0.19% and the Japanese 10-year yielding 0.34%. We expect this relative valuation game to continue to provide some support to the equity markets, with investors needing to become very concerned about the growth outlook before valuations are likely to come under pressure. The other potential game-changer would be a jump in interest rates, which would immediately feed through to less-attractive risk asset valuations and more competition from bonds. We remain of the view that this is not a likely scenario over the next five years.


The market’s obsession with earnings is unlikely to end soon, but hopefully our work provides a useful framework to consider the impact of earnings. While individual company reports will continue to have a meaningful impact on that particular equity, the impact of overall earnings on the market tends to be a long-term affair. The primary exception is those instances of the “double recession,” where clairvoyant traders could profit by selling the market ahead of the recession and buying back near its end. Analysts have cut earnings forecasts for 2015 and 2016 to reflect the drop in energy prices, and the overall pace of earnings growth is fairly consistent globally. We don’t expect today’s equity market valuations to be a headwind to returns over the next year, but do believe they will impact longer-term returns. A significant downturn in economic growth is the most likely enemy of the stock market, but we expect moderate and durable growth to continue over at least the next couple of years.


November 11, 2014

Mood Swings

Jim McDonald Image/Headshot Jim McDonald
Chief Investment Strategist
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While market volatility has been well below average over the last two years, we have seen a spike in daily moves greater than 1% over the last month (as shown in Exhibit 1). In fact, if one annualized the October 1% market moves, the frequency would approach the levels of 2008 and 2009 (although the frequency of moves of greater than 2% would be lower). This pickup in volatility has led some investors to ask what this means for future market returns, and whether there are reliable signals that can help divine the next correction in the market. We recently reviewed the efficacy of various market indicators, like investor sentiment, volatility and margin debt, and found there is only modest value that can be gained from analyzing investor sentiment indicators. We also examined a more fundamental building block – valuation – as a timing tool, and found that while valuation has little near-term value in predicting market returns, it is valuable on a long-term basis.  For this reason, we look to valuations to help forecast long-term returns. The markets that have been underperforming U.S. equities are generally trading at relatively attractive valuations – increasing their long-term return potential. This bolsters the case for a strategic allocation to these markets, and cautions against throwing in the towel on underperforming regions.

Sources: Northern Trust, Bloomberg. “Big move” trading days are market moves of more than 1%. Historical averages are from 1972 to present. 

In Exhibit 1, we define “big move” trading days as days when the market moves by more than 1.0% (up or down). For context, this equates to a 175 point day on the Dow Jones Industrial Average at current price levels. Looking at big move days helps put the concept of standard deviation into a more understandable framework. For instance, MSCI World volatility – as measured by standard deviation – during the 2008-2009 time frame was 25.6%. But perhaps more relevant was the fact that markets suffered 61 and 46 days of greater-than 1.0% declines in 2008 and 2009, respectively – versus the historical average of 19 days a year with losses of that magnitude. Lately, we have enjoyed a below-average number of “down days” – with only 12 in 2013 and only 12 in 2014 (through October 31). However, looking at the monthly numbers, we clearly saw a spike in October – both in terms of “up days” and “down days” (four each). Is there anything volatility – and other sentiment indicators – can tell us about the future path of the markets?

In Exhibit 2, we analyze the relationship between volatility and subsequent market performance by looking at the monthly Chicago Board Options Exchange S&P 500 Volatility index level (VIX) against subsequent one- and 12-month S&P 500 returns. Splitting the VIX levels into three buckets shows that no significant difference in future returns exists. The R-squared between the VIX and next 30-day returns is just 0.03, meaning that it only explains approximately 3% of S&P 500 return variability. Meanwhile, the longer-term measure is even worse with an R-squared of just 0.004, meaning the VIX explains approximately 0.4% of S&P 500 return variability. The range of realized returns does, however, increase as volatility rises.


Sources: Northern Trust, Bloomberg. Study uses monthly data from 1/31/1990 through 10/31/2014.

As we dig deeper into the details, we see further evidence that this is not a very predictive model. For example, when the VIX reaches 26, the expected return is around 11%, but ranges between -40% and 20%. Interestingly, when the VIX rises above 40, market returns have been positive 100% of the time on a 12-month basis. However, the 30-day returns illustrate that you would have to take some short-term pain before realizing this longer-term gain.

Along with the strong rise in the markets over the last five years, margin debt has been accelerating and has become a recent concern of investors – both because of the elevated levels it has reached on a nominal basis (currently at $464 billion) and the way in which previous peaks in margin debt have coincided with substantial downturns in the markets. However, looking at the level of margin debt when scaled by the size of the U.S. equity markets (using the S&P 500 market cap as our proxy) paints a less dramatic picture (see right panel of Exhibit 3). By this measure, current levels of margin debt are more or less consistent with the trend line over the past 20-plus years. This secular upward trend is most likely a reflection of continually falling interest rates (and, thus, falling margin debt servicing costs). Other secular factors at play include the proliferation of hedge funds (hedge fund data is included in the margin debt metrics) and financial innovation whereby taking on margin debt today comes with substantially less friction than in the past.


Sources:  Northern Trust, Bloomberg. Monthly data through 9/30/2014. S&P 500 used to proxy U.S. market cap. 

Turning to the prospect of the recent run-up in margin debt signaling an imminent downturn in the markets (as appeared to happen in 2000 and 2007), we are less convinced. Again, on a relative basis, current margin levels are fairly contained. Furthermore, we cannot be certain of the cause and effect of the recent margin debt peaks. We believe it is more likely that the market sell-offs caused the reduction in margin debt and not the other way around. Because margin debt can be used for “betting against” as well as “betting on” the market – and can even be used for things that have nothing to do with the market (e.g. an individual’s desire to consume) – it makes sense to dive into indicators that provide a better read on investor sentiment. We discuss three in particular: investor sentiment surveys, put/call data and fund flows.

As a measure of individual investor sentiment, the American Association of Individual Investors (AAII) asks individual investors whether they are bullish, bearish or neutral on stocks over the next 6 months. Individual investors do tend to be a reasonable contrarian indicator – as their moods tend to reflect what has already happened in the markets as opposed to what is about to occur. During periods where investors were excessively bearish or bullish, the surveys have been a fair market timing indicator. When there’s excessive bearishness in the surveys, the median market return over the next month is 23.3% (annualized), and over the next 12 months is 16.2%. When there’s excessive bullishness, the return over the next 30 days is just 3.8% (annualized), and over the next 12 months is 9.4%. Investing during periods of excessive bearishness had a 58% (one month) and 65% (12 months) probability of outperforming the market’s normal-sentiment returns. This strategy has a reasonable “hit rate,” or probability, of success when looking at the 12-month returns.

When we use a stricter definition of excessive bearishness – a two standard deviation move – the S&P 500 returned 29.8% over the next 30 days (annualized, with a 66% hit rate) and 23.0% over the next year (a 69% hit rate). This is a rare event, happening only 35 weeks in the history of survey. The last time there was a two standard deviation level of bearishness was in March 2009 – and the S&P 500 subsequently gained 65% over the next 12 months.


Sources: Northern Trust, Bloomberg, Morningstar. AAII surveys: weekly since July 1987; CBOE puts and calls: daily since January 1997; Morningstar flows: monthly since February 1993.  Three-week smoothing used for survey and puts and calls data. 

We next turn to daily put and call volume on the Chicago Board Options Exchange (CBOE), focusing on call volume (bullish bets on the markets) as a percent of total put and call volume. To reduce the impact of professional institutional hedging activity, we excluded index option volume. Our analysis shows that analyzing put and call option volumes is a less useful indicator than individual investor sentiment surveys.

When the CBOE reported excessive call volume, the median market return over the next 12 months was about 7.7%, actually above the 7.2% return when there was excessive bearishness. The distribution was non-normal – excessive bullishness only happened 4.6% of the time, while excessive bearishness happened 31.7% of the time. Markets tend to have more call writers than put writers – and data don’t appear to be mean-reverting – as there has been a slight downtrend over the last 15 years, possibly reflecting the increasing presence of long-short equity hedge fund strategies. This study performed better on a 30-day basis as the median return during excessive call-writing was a negative 9.8% (annualized) over the next 30 days, versus 15.9% when there was excessive put-writing. The hit rate of reducing equity exposure during a bullish market was nearly 60%, which isn’t bad but would require a long-term systematic program to capitalize on it.
As a final gauge of sentiment, we looked at the flow of money into and out of risk assets (e.g. stocks) and risk-control assets (e.g. bonds). We included U.S.-domiciled open-ended mutual funds, ETFs and money market funds. Fund flows can be a solid contrarian indicator on a 12-month horizon. The median market return when investors are taking risk off the table is 13.6% over the next 12 months – better than the 11.4% return when risk is on, but with just a 56% hit rate. On a
30-day basis, the market has outperformed when more money is flowing to risk assets (14.7% versus 10.7%, annualized), a logical occurrence since fund flows can be a technical contributor to short-term momentum.

While sentiment can swing markets in the short-term (one year or less), over a long-term horizon (five years or more) the single best predictor of equity market return variation that we can find is valuation. Cash flow yield is our preferred valuation measure to assess valuation levels. Given its recent popularity, we also assess the cyclically adjusted price-to-earnings ratio (CAPE), which uses a 10-year rolling earnings number for earnings. Looking at the data on a one-year basis shows that valuations provide little insight – with cash flow yields and CAPE explaining only 11% and 7% of return variability, respectively. However, on a five-year basis, cash flow yields and CAPE explain 43% and 37% of return variability, respectively. Coincidentally, both valuation measures currently predict a 6.4% annual return for U.S. equities over the next five years, below the 10.1% long-term historical average (data back to 1926). As we include valuations in our Capital Markets Assumptions work, this is fairly close to our forecasted 6.6% return for U.S. equities.


Sources: Northern Trust, MSCI, Bloomberg, Yale University. CAPE data used in “Irrational Exuberance” by Robert Shiller. U.S. market proxy: S&P 500.

In Exhibit 5, we convert the CAPE to an earnings yield figure to provide comparability with the cash flow yield data. Many investors are concerned about the heights CAPE has reached, currently standing at 26.3. Since 1881, the CAPE metric has only surpassed this level on three occasions, with peaks occurring in 1929, 1999 and 2007 – all preceding major market drops. However, some (including us) question the validity of the CAPE in the current environment given the massive fall in earnings during the financial crisis (the 2008 earnings still suppress the 10-year earnings figure). Furthermore, while CAPE is currently stretched, it has been that way for some time – with the metric sitting above 20 since 1995, with a brief exception during the financial market crisis. As Robert Shiller, the co-developer of the CAPE ratio, said in an August 17, 2014 NY Times article  “The United States stock market looks very expensive right now. The CAPE ratio, a stock-price measure I helped develop — is hovering at a worrisome level.” However, he went on to say “The CAPE was never intended to indicate exactly when to buy and to sell. The market could remain at these valuations for years. But we should recognize that we are in an unusual period, and that it’s time to ask some serious questions about it.”  In our opinion, it seems as if Professor Shiller also believes the CAPE is a good long-term predictor of returns, but not a short-term trigger.

Valuations are one major component of our Capital Markets Assumption (five-year) return expectations, alongside earnings expectations and dividend yield assumptions. Looking at developed markets, we expect similar earnings growth across the various regions (approximately 5%). While we do expect Europe and Japan to show slower economic growth than the United States, the composition of company revenues in those regions allows better earnings potential than would be suggested by the company’s country of domicile. For instance, companies in slow-growing Europe get nearly 50% of their revenues from outside of the European bloc (including nearly a quarter of their revenues from emerging markets) making those companies the most geographically diversified of all regions (by comparison 70% of U.S. company revenues come from the United States).

1Shiller, Robert J. “The Mystery of Lofty Elevations.” New York Times 16 Aug. 2014: BU3. Print.


 Sources: Northern Trust.

While our earnings expectations across developed markets are similar, the forecasts for higher dividend yields in Europe, and slight multiple expansion, gives Europe a forecasted return advantage over the United States. Looking at emerging markets, the higher earnings growth potential (with 84% of revenues coming from domestic sources) alongside a solid dividend yield and some valuation expansion lead us to continue to expect a return premium out of those equities relative to the developed markets. The current sentiment toward many major equity markets outside the United States is soured by recent underperformance. However, the improved relative valuation increases the relative return potential and we think supports a better 5-year return expectation. We think this justifies a continued commitment to a globally diversified equity portfolio, which helps reduce dependency on any one region and reduces the risk of materially underperforming a global equity universe.

Special thanks to Raymond Luo, Investment Analyst, for data research.

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IMPORTANT INFORMATION: This material is for information purposes only. The views expressed are those of the author(s) as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believed to be reliable, but the accuracy cannot be guaranteed.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.