Are Corporate Earnings and P/E Ratios a Leading Stock Market Indicator?

As usual, Alcoa kicked off the quarterly earnings ritual. Corporate profits will be on display for weeks to come, but are earnings a leading or lagging indicator? Here’s the long-term effect of earnings on stocks and the one pattern worth watching right now.

‘Tis the season to get jolly about earnings. The quarterly earnings ritual pays a visit every quarter and captures the interest of Wall Street and Main Street alike.

How much do corporate earnings affect stocks? Are earnings a leading stock market indicator?

A chart says more than a thousand words and the one below plots the S&P 500 against US corporate profits measured in nominal dollars and corporate net profits as a percentage of GDP.

Fundamental analysts use earnings per share (EPS) and P/E ratios to figure out where a stock should be trading. By extension the same process is applied to broader indexes, like the S&P 500 or Dow Jones.

As evidenced by the chart, there has been an obvious correlation between profits and stock prices (at least since the late 1990s), but its not as snug as some analysts make it seem.

Corporate profits rolled over several quarters before the stock market peaked in 2000 and 2007. In hindsight, one might extrapolate that corporate profits are a leading indicator.

However, the problem is that profits aren’t known until well after the fact. Earnings are released after the fact and the Bureau of Economic Analysis (BEA) reports quarterly profits with a 3-month time lag.

In addition, who knows if a one-quarter decline is just a one-quarter chink in the chain leading to higher prices or the beginning of the next recession?

If you’re inclined to wait for a second quarter, you’re already talking about a 9-month time lag. The long-term earnings picture provides little direction for short-term investment decisions.

Here’s a short-term first quarter earnings pattern that’s worth watching. Solid earnings, even record earnings, have been followed by weak stock performance in April/May.

Earnings Euphoria: Precursor to Bearish Mean Reversion?

Corporate America has never before seen higher profits than now. Are healthy profits a reflection of a healthy economy or have earnings reached a point of unsustainability?

In good old times past it used to be that when complacency reigns on Wall Street, investors get wet. It’s different in a QE world; When complacency reigns, investors get wet eventually. Are investors complacent?

Bloomberg reports: “With 72% of earnings exceeding analysts’ estimates, it may be difficult for U.S. stocks not to reach a record in 2013. The S&P 500 is poised to recover fully from the financial crisis that began almost six years ago.”

According to 11,000 analysts’ estimates compiled by Bloomberg, profits of S&P 500 companies are expected to exceed $1 trillion this year, 31% more than when the gauge peaked. Bloomberg calls this the “biggest expansion in profits since the technology bubble of the 1990s.”

This is a bold statement. There was not only the earnings explosion of the late 1990s, there was also the financial leverage earnings explosion of the mid 2000s. In 2007, earnings of the financial sector (corresponding ETF: Financial Select Sector SPDR – XLF) accounted for over 40% of all U.S. profits.

It’s hard to believe that S&P 500 earnings today are 77.6% higher than at the 2000 peak and 10.3% higher compared to the prior 2007 all-time high.

A voice of reason often tends to get over looked in an unreasonable world, but the chart below reminds us of unpopular past realities. Mean reversion took many by surprise and earnings peaks turned into stock market peaks.

What do earnings tell us about stocks? Corporate earnings aren’t a short-term timing tool and shouldn’t be used as such, but record earnings sow the seeds for subsequent declines.

The S&P is currently trading just above a major long-term support/resistance level. As long is it remains above support, stocks may grind higher, but a trip below may quickly turn into a fast and furious decline.

The Profit Radar Report highlights the support and risk management levels needed to avoid a surprise move.