The Stock Market is a Voting Machine

By Charlie Bilello

20 May 2022

Hence the prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly, but only as they affect the decisions of buyers and sellers.” – Graham and Dodd, Security Analysis (1934 Edition)

“Earnings drive stock prices.”

This is one of the oldest maxims in investing. As earnings rise or fall, stock prices are said to move higher or lower by a commensurate amount.

But is this actually how it works?

At first glance, it certainly seems so. In looking at a simple chart, earnings and stock prices appear to move in tandem.

But appearances can be deceiving. While earnings and stock prices tend to move together over long periods of time, in the short run there can be enormous divergences.

For instance, there have been years in which earnings fell while stocks moved higher (1991, 2007, and 2020) and years in which earnings rose while stocks moved lower (1994, 2000, 2002, 2011, and 2018).

In most years (76% of the time since 1989), earnings and stock prices move in the same direction, but the magnitude is often far from equivalent. For example, in 1998 earnings rose 0.6% while stock prices advanced 26.7% and in 2001 earnings declined 30.8% while stock prices declined only 13.0%. And in 2021, we saw the widest differential ever, as stock prices rose 26.9% while earnings surged over 70%.

What is the source of these discrepancies?

Changes in investor sentiment, what Graham and Dodd called the “voting machine.” This shift in sentiment leads to an expansion or contraction in multiples (ex: P/E ratio) that oftentimes supersedes changes in earnings.

1991 and 2020 are the most extreme examples of this phenomenon:

  • In 1991, earnings fell 14.8% while stock prices rose 26.3%. The result: a multiple expansion of over 48%, moving the P/E ratio on the S&P 500 from 14.6 to 21.6.
  • In 2020, earnings fell 22.1% while stock prices rose 16.3%. The result: a multiple expansion of over 49%, moving the P/E ratio on the S&P 500 from 20.6 to 30.7.

When changes in prices exceed changes in earnings, multiples expand. When changes in earnings exceed changes in prices, multiples contract.

Over the past few years, we’ve seen big swings in both directions, as multiples expanded significantly during 2019 and 2020 followed by a contraction in 2021 and thus far in 2022.

What will happen throughout remainder of the year?

As we have seen, the answer to that question depends not only on changes in earnings but also changes in sentiment.

According to S&P Dow Jones, S&P 500 operating earnings are currently expected to increase 7.7% in 2022 (moving from $208 to $224).

If these expectations are correct and the S&P 500 ends the year higher by 7.7%, the P/E multiple would remain unchanged from where it ended 2021 (at 22.9).

While it’s possible that could happen, it should by no means be expected. In two-thirds of years since 1989, there has been more than a 10% change in the P/E multiple.

We’re seeing that yet again thus far in 2022, with stocks down sharply, resulting in an 18% multiple contraction (based today’s prices and trailing 12 month earnings through Q1).

Why are multiples contracting this year? Take your pick: lower earnings expectations, worsening economic outlook, tightening central bank policy, rising interest rates and inflation, war, etc.

Basically anything that influences investor sentiment can impact the multiple investors are willing to pay, and this year there’s been no shortage of “reasons” for sentiment to sour. With hindsight, these explanations seem obvious, and the change in multiple predicable. But that’s always the case after the fact as we can rationalize just about anything.

The truth: predicting changes in investor sentiment is a very difficult game, which means that even if you could predict future earnings (no small task), it would be impossible to say what the S&P 500 would do.

Above all, the stock market is a voting machine. It always has been and it always will be.

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