When high aggregate earnings mean lower market returns

Researchers are coming to grips with a puzzling US anomaly

When analysing the world of finance, it makes sense that share markets generally follow earnings.

It seems so simple. A company makes more money, therefore its share price goes up; and if there is a rise in aggregate earnings – that is, the total of all companies' earnings – then the market rises, too.

But is this really true of aggregate markets? It's a key question because investors want to forecast the market and decide how to allocate their funds between shares, bonds and other assets.

In their recent paper, Aggregate Earnings and Market Returns: International Evidence, UNSW Business School senior lecturers Wen He and Maggie Hu acknowledge that it's "well documented that firm-level earnings are positively related to contemporaneous stock returns" in the US and non-US markets.?

"This positive association has been generally interpreted as suggesting current earnings news conveys information about future cash flow," they write.

However, academic researchers in 2006 and 2009 have found something surprising: in the US, this supposedly logical outcome is not always the case. He and Hu point to the work of Kothari, Lewellen and Warner, who documented that "aggregate earnings changes in the US are negatively related to contemporaneous market returns".

As He and Hu note: "The stark contrast between the firm-level and market-level evidence presents a puzzle and has evoked follow-up studies attempting to better understand the relations between earnings and returns."

He and Hu's own study considers whether this negative association between aggregate earnings and market returns is specific to the US or more widespread.

Collecting data on earnings and returns for a sample of 18,727 companies from 28 countries, they examined a time period from the late 1980s until 2009. They also investigated various explanations for the US experience.

"It was a lengthy research process that started in 2011 in Singapore," He says.

"I just came across this information in the US and found it was quite interesting, so I wanted to see whether we could find the same anomaly in other countries of the world."

He and Hu have discovered it is "unique" to the US.

"[Whereas] in most markets, including Australia, the market index does go up more when aggregate earnings are higher than expected," He says.

Transparency and predictions

For Nick Griffin, head of international equities at K2 Asset Management, his experience is that markets generally follow earnings.

"So [for] companies that make more money every year, generally their share price goes up and that goes for the whole market as well," Griffin says.

Better transparency allows people to make better predictions

Wen He

But he notes that some things may affect this scenario. One, is that markets are forward looking.

"So if earnings were rising this year and next year we thought they were going to fall, the market wouldn't wait until next year to go down – it would go down this year in expectation of falling. But generally these things are moving six to 12 months ahead and that's the same in most parts of the world," Griffin says. 

And does a more transparent disclosure regime in the US have an impact on markets?

"Yes, 100%," Griffin says. "Capital goes where capital is treated best. And transparency is very important, good corporate governance is very important, and good rule of law is very important. All those things add to provide a more efficient market."

Such transparent corporate disclosure in the US, He believes, does assist investors to forecast aggregate earnings and adjust their appetite for risk.

"Better transparency allows people to make better predictions, which explains this puzzle or anomaly in the US," He says.

"In other countries, because of less transparent disclosure, aggregate earnings are less predictable, so people have to rely on the news to judge the price."

Griffin, however, is not sure an anomaly exists in the US.

"There are plenty of markets that behave exactly the same as the US," Griffin says.

"The UK does, Australia does, parts of Europe do. If focusing on results, then maybe the data can throw up some different stuff – but in the 10 years that I've done this, generally if earnings are going up the market's going up."

But according to He, the US simply has more people predicting aggregated earnings and better company disclosure – resulting in better predictions.

"The key implication of this is when people can predict what's going to happen next year they can adjust their risk aversion … For example, next year in the US we expect very high earnings and people will say 'next year is going to be a good year, so I'm going to take more risk'," He says.

Leadership and rotation

Chris Weston, chief market strategist at IG, believes markets will follow earnings "to a degree".

"But there's always going to be an element of sentiment and global macro forces that come through," Weston says.

One thing Weston always watches is the participation in a market rally, while he adds that one of the more interesting ways of looking at markets is through "breadth". 

You get leadership and then you get rotation. That is the issue

Chris Weston

For example, at the time of this article, the S&P 500 index in the US was 1% from an all-time high, but the level of companies above their 200-day moving average was the lowest for some time. The reason? Fewer companies were taking part in the rally.

"So the US market now is relying much more on leadership from a very specific group of companies which have a very high weighting on the market," Weston says.

"In 2000, we had 95% of companies above their 200-day moving average; we've got 55% now… You get leadership and then you get rotation. That is the issue."

Weston believes there is no discernible trend in Australia, with the percentage of stocks above their 200-day moving average showing a strong correlation with the index.

"You could make an argument here that when the market undergoes a strong move [in the ASX 200], participation is broad and a rising tide generally lifts all ships. Traders are not as selective as they are in the US, for example, where we are seeing leadership in much more concentrated segments of the market," Weston says.

 Aggregation

Although He and Hu's results show the US experience to be singular, it doesn't mean American markets are not functioning properly – and can, in fact, be good for investors.

"Because of that particular feature about transparency people actually adjust their risk aversion better," He says.

He and Hu are looking to continue their research and will look again at the US.

"When you look at individual companies it's all positive. So at what stage, or how, does this aggregation change the relationship from positive to negative? That's what we're trying to examine," He says.