Stock Prices are Overdue to Align with Earnings

By Ernie Ankrim, Chief Investment Strategist
Russell Investment Group
Global Leaders in Multi-Manager Investing

March 13, 2006

No one will argue that U.S.equity returns have disappointed over the past four years. The question is, why? It's true that global political issues and Mother Nature's destruction have caused some risk-shy investors to consider equities one more potential danger.

However, a peek at the numbers that define the U.S.stock market certainly doesn't support a case for gloom. Quite the contrary, in fact.

Reported earnings growth of publicly traded companies over the past four years has been extraordinary, and by rights, stock prices typically recognize and reward this. So it's been disappointing to have such an apparent disconnect between the two.

As you're about to see, this disconnect between earnings and stock prices is an anomaly. Short periods can generate exceptions, but over long periods there has historically been a close relationship between stock prices and earnings.

32 Years Tell the Story
The following chart compares movements of the Standard & Poor's Security Price Index Record versus the reported earnings of companies in the S&P 500 Index between 1974 and January 2006, as documented by S&P. At first glance you can see that the two lines run close to parallel much of the time. Because these data are plotted on a logarithmic scale, the slope of the line translates into a percentage rate of growth. As you can see, the rate of growth of prices is on occasion slightly higher than the rate of growth of earnings — but the long-term relationship is undeniable.

32 Years of Growth
Y axis = S&P 500: Index Value and $ Earnings (logarithmic scale)

What conclusions can we draw from this? To begin with, if earnings continue to grow at some given rate, this should give proxy for the rate at which prices of securities in the Index are expected to grow — historically between 7% and 8% per year. There may be times that people get overly optimistic to cause prices to go up even faster, and times that people get overly pessimistic to cause prices to move much slower. Ultimately, earnings growth is expected to translate into eventual price increases.

The Environment is A-Changin'
Over this 32-year period, the rate of growth of prices turned out to be about 8.4% per year, while earnings grew 6.97%. They're not exactly identical, but there's a reason why. If the interest-rate environment at the beginning of the period is dramatically different from the end, we can not only see a difference, but also account for it.

The average interest rate from our first four years of data, 1974 through 1977, was 9.71% as measured by the average yield-to-maturity of Moody's Baa-rated corporate bonds. Over the 2002 through 2005 period, the average rate was 6.76%. Based on this difference in interest-rate environments, the average growth rate in prices should have exceeded the average growth rate in earnings by about 1.14%. As it happens, the difference over this period was 1.43% — so almost 80% of the difference of the rates of growth between earnings and prices can be explained by lower interest rates.

Anything's Possible, But ...
Over shorter periods, these two rates of growth can differ quite dramatically. But the long-term relationship fits well, and in this 32-year period, prices have adjusted to sync with earnings. So when we reach one of these periods of disparity, we can take it as a sign we are either heading for serious price disappointment or serious price increases.

For example, let's consider the four 48-month periods where stock price growth most exceeded earnings growth. Not surprisingly, they were the "irrational exuberance" periods ending January 1999, March 1999, April 1999, and June 1999 when the U.S.stock market was driven to all-time highs by speculative investors hoping to cash in on the tech-stock boom. In the most extreme of these months, April 1999, the S&P Index rose by 159% while the earnings on the Index rose by only 21%. This could not continue forever, and 2000 was just around the corner.

Of course, there have been periods in which the four 48-month periods had earnings growing much faster than prices. For the 32 years of data there hasn't been a more dramatic example of this than the 48 months ending January 2006. During this latest four years, the earnings grew by 136% while the four-year change in the Index was a miserly 13.2% as stock market returns were dictated by non-earnings news.

So what we now have are 48 months of stunning earnings growth, with the owners of equities not being rewarded for that growth. For this four-year period to continue, it would stretch the unique, stable relationship between equities and earnings beyond reason. That's why I'm positive on the current prospects for equity returns in the United States. And why I think the recent pattern is not likely to continue for long.