Stocks Are In A Bubble, Or Earnings Just Don't Matter Anymore

| About: SPDR S&P (SPY)

By FS Staff

One look at the chart below, and it's pretty easy to conclude that either earnings don't matter anymore or stocks are in a bubble.

The black line is the S&P 500 (NYSEARCA:SPY), which just closed at a new all-time record, and the red line is total earnings for S&P 500 companies. Clearly, there's a disconnect between the two at present.

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Earnings peaked in the first quarter of 2015, and the S&P 500 peaked soon after just a couple months later in the second quarter, which makes sense if earnings - one of the main and most closely watched determinants for stock prices - matter.

However, since then, stocks have moved sideways (and now to new highs), while earnings have consistently declined five quarters in a row.

Does that mean stocks are ready to crash?

When we compare the behavior of stock prices and earnings going back a few decades, we see that sometimes they do move in opposite directions.

In fact, there's been a number of occasions where stocks rose - sometimes quite dramatically - even while earnings consistently slid lower (see green shaded regions below).

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One of the main reasons cited currently for why stocks are hitting all-time highs even though earnings have continued to decline is that investors have no other place to put their money.

With bond yields trading at all-time record lows, investors are "forced" to meet their return requirements by purchasing a combination of higher-yielding, dividend-paying stocks or corporate bonds.

This problem is most acute when we think of underfunded public pension funds, as Brian Reynolds at New Albion Partners explained on our podcast last year.

Consider "How a Public Pension Crisis Is Driving an Epic Credit Boom":

"Pension funds," he said, "have to make 7.5%," so they are putting their money "in these levered credit funds that mimic Long-Term Capital Management in the 1990s." Those funds, in turn, "buy enormous amounts of corporate bonds from companies which puts cash onto company balance sheets... and they use it to jack their stock price up, either through buybacks or mergers and acquisitions."

"It's just a daisy chain of financial engineering and it's probably going to intensify in coming years," Brian said.

Apparently, companies are now spending more of their own money on dividends and buybacks than on long-term capital investments. How long this can be sustained is unclear.

More recently, the push to all-time highs in the stock market is being attributed to a stronger-than-expected payroll report that came out last Friday, which helped to reduce fears of an imminent slowdown in the US.

See "S&P 500 rises to new record as global stocks rally":

The S&P 500 surged to a record Monday, joining a global equity rally as Wall Street brushed aside worries about the global economy and awaited second-quarter company earnings...

The gains on Wall Street reflected continued momentum from Friday's surprisingly strong US jobs report, which raised hopes that the American economy was strengthening.

However, as we showed last week (see "15 Warning Signs of Possible Market Top, Recession Next Year"), US labor market conditions have certainly deteriorated.

The Conference Board's Help Wanted OnLine Index plunged again in June and also agrees with the message coming from Real Time Macro's online jobs data, which continues to raise a red flag versus the official government data.

Just recently, analysts at the Federal Reserve acknowledged the discrepancy between these two sources and wrote a "cautionary note" on using online data sources due to an apparent Craigslist effect, which may be giving the impression that the jobs market is much weaker than it actually is.

Real Time Macro's Jon Hartley, however, isn't buying it.

Here's what he had to say in a recent email:

"It appears like online job openings are falling independent of this 'Craigslist effect'. Falling job openings have historically been leading indicators of recessions and rising unemployment. Sure NFP rebounded in June but BLS NFP is a very noisy series and I think the broader trend is still moving in a negative direction given the prior month's drops."

Again, that seems to agree with our 15 warning signs presented last week. On Wednesday, we'll be speaking with David Rosenberg on our premium podcast to get his thoughts on where the world's largest economy is headed, so be sure to tune in then to hear what he has to say!