Fisher Investments Canada on the relationship between earnings and equities

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Owning equities entitles investors to a share of companies’ future earnings. That said, we often think investors focus too much on what companies’ latest earnings reports mean for equities. We believe that is a backwards approach, based on Fisher Investments Canada’s review of historical market returns and earnings data. We think equities anticipate future earnings. So while earnings reports may confirm what equities already priced in, gauging where equities go likely requires considering how earnings will evolve over the next three to 30 months, in our view.

Earnings are companies’ financial results – typically released quarterly or semi-annually – and these reports include information on the value of companies’ sales, costs and profits. Earnings are reported on a total and per-share basis, consistent with equities being a share in corporate earnings. In Fisher Investments Canada’s experience, analysts often look at whether sales and profits grew, fell or stayed the same compared with the most recent or year-ago quarter – and how this information related to expectations. Management also typically releases guidance for the upcoming quarter and year, and executives will often hold a public conference call with investors and analysts, discussing the results and taking questions. These figures and commentary give investors a look at how the business is doing and what management projects in the near future – helping to reframe projections.

Earnings provide important information to equities but, based on Fisher Investments Canada’s review of mainstream earnings commentary, not in the way headlines portray. Our research shows equities are forward-looking indicators, assessing probable outcomes in the next three to 30 months. Since equities are a share in earnings, rising share prices may reflect profit or sales growth over this time period. But crucially, in our view, equities move ahead of earnings. Look at America’s S&P 500 returns and earnings-per-share performance – used here for its long history of earnings data – since 1999.

Exhibit 1: S&P 500 Total Return Index and Earnings Per Share (EPS) Since 1999

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According to Fisher Investments Canada, as the chart shows, equities usually change direction before earnings do at both the beginning and end of bear markets (typically broad market downturns of -20 per cent or worse with fundamental causes). But even this doesn’t totally capture equities’ tendency to move first, as earnings are reported after the fact. For example, during the October 2007 to March 2009 bear market, earnings per share started falling on a year-over-year basis in Q1 2008.1 But companies didn’t share those results until that quarter’s earnings reporting season, which spanned 2008′s second three months. Then, at the bear market’s end in early March 2009, equities began rising but earnings didn’t resume growing until 2010.

Fisher Investments Canada thinks there is a logical reason equities move first. Earnings are a function of economic activity at any given time, which equities price in as it happens; they don’t wait for data to confirm what happened. Earnings reports are a lagging confirmation of the developments equities already priced in. By the time they come out, we think equities have already moved on to pricing the future. Hence, in our view, analyzing earnings reports is of limited use in forecasting other than to assess trends and how they developed against earlier forecasts.

Instead, we think it is more beneficial to look at the factors that influence earnings over the foreseeable future – namely, the political and economic backdrop, and to what extent the potential positives and negatives are accounted for in popular sentiment. On the economic level, Fisher Investments Canada reviews leading indicators such as the new orders subcomponent of Purchasing Mangers’ Indexes (PMIs), which are monthly surveys that track the breadth of economic activity. Today’s orders are tomorrow’s production, so when this component is expansionary, it implies future economic activity. Another useful, forward-looking indicator is global loan growth, which signals credit availability. According to our research, easier credit access implies capital flowing to businesses and households, which they can then use to expand and invest.

On the political front, Fisher Investments Canada reviews whether governments are likely to pass legislation that would make big, sudden changes to taxes, regulation, property rights or other factors that could reduce the incentive to invest. Take, for example, the U.K.’s Energy sector windfall taxes, introduced last May and increased in November. Subsequently, Offshore Energies UK reports: “95 per cent of [energy companies] surveyed had been ‘negatively impacted’ by the levy and were ‘looking to invest elsewhere.’”2 U.K. Energy equities have risen since then, but they trailed their global counterparts for about half a year after the tax was introduced.3 Or, look at America’s 2002 law called Sarbanes-Oxley, which aimed to combat corporate accounting fraud. It increased compliance costs for businesses and, in our opinion, extended the 2000 to 2002 bear market.4

Simply determining whether earnings are likely to fall doesn’t mean equities are sure to do the same, as Exhibit 1 also showed; earnings’ weak patch in 2015 didn’t trigger a deep equity market downturn. However, by assessing whether the broader market as well as a given sector or even company’s earnings are likely to turn out better or worse than most analysts project, Fisher Investments Canada thinks it can help form a market outlook and assess which areas are likely to do relatively better in a given environment.

Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates. This document constitutes the general views of Fisher Investments Canada and should not be regarded as personalised investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments Canada will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

Fisher Investments Management, LLC does business under this name in Ontario and Newfoundland & Labrador. In all other provinces, Fisher Asset Management, LLC does business as Fisher Investments Canada and as Fisher Investments.

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