Earnings Are Horrible, But It May Not Matter

Includes: DIA, QQQ, SPY
by: Babak

First the bad news: earnings are horrible. Downright depressing actually. As the chart below illustrates, we’ve seen nothing short of an utter collapse during the most recent bear market:

historical earnings S&P500 chart of the day
Clearly what we’re going through is not your average, plain-vanilla recession. That would be the blue dashed line above. Even the last recession which came about as a result of the popping of a massive speculative bubble in technology shares and topped off by the economic body-blow from the September 11th attacks pale in comparison. What we’re seeing is the single most severe drop-off in earnings on the record.

Now for the good news. It may not matter at all - that is, when it comes to the stock market. Of course, to the economy, the employees and companies involved there is a significant consequence and I don’t mean to trivialize it. But the stock market is not the economy. For an example of what I mean, consider the company that started the most recent earnings season.

Alcoa (NYSE:AA) released their earnings report after market close on Tuesday. They reported a loss of about half a billion for the first quarter. As you might expect, at first its stock price fell in after-hours trading but it closed higher the next day (Wednesday shown by green arrow) and Thursday it gapped up and closed almost 10% higher:

alcoa AA - earnings reaction Apr 2009

Is this normal? Yes, of course. In contrast to what you may have heard, stock prices are not driven by earnings. This is one of the key characteristics of the stock market that throws a lot of novices because it just doesn’t make sense. But it does, once you realize that prices are set by a number of factors and while earnings are certainly part of the recipe, they are not the dominant ingredient.

If you look at enough charts you’ll see stock prices that are falling for companies that are reporting increased earnings and also stock prices that rise with decreased earnings. The key isn’t earnings, which after all, can be heavily manipulated, unlike dividends. But rather the meaning that investors attribute to them. In other words, the price-earnings ratio. And that, is all about “animal spirits” or sentiment.