One issue with following financial markets on a daily basis is that one might fail to see that wood for the trees. Prices fluctuate on a daily basis for many reasons, so it’s difficult to maintain a sense of balance.
Ultimately, stock market prices are linked to long-term earnings trends. If earnings grow faster, prices rise. If earnings are flat or negative, prices tend to fall. There can be short-term aberrations. Excess liquidity can result in higher prices even when earnings growth is weak. Earnings may also grow fast during bearish periods. But the long-term relationship between faster earnings growth and rising prices is solid.
The last few years have seen extraordinary events in global financial markets. Through 2005 to 2008, there was a flood of liquidity. That created a bubble that drove up stock prices everywhere. From 2008 to 2012, it’s been up and down.
First, the bubble deflated. Then, governments pumped in a huge dose of liquidity that re-inflated the bubble temporarily. But after the Greek crisis, the global economy went into recession again and equity prices dropped.
Earnings grew very quickly through 2005-2008. The broad CNX500 (which tracks the 500 largest companies by market cap) saw fantastic earnings CAGR of 24.6 per cent between January 2005 and January 2008. Thereafter, there was a marked slowdown. Between 2008 and 2011, earnings grew at a meagre three per cent CAGR. Between 2011 and now, earnings CAGR slowed even further, to 2.4 per cent.
Overall, the CAGR for the entire period of seven years and eight months has eased to 10.8 per cent, which is respectable but not amazing. Inflation through this period has grown at a CAGR of 6.7 per cent in terms of the wholesale price index (WPI). So, earnings of listed businesses have beaten inflation by a handsome margin overall.
Prices have followed suit. Between January 2005 and now, the CNX500 has moved from 1,834 to 4,176, a CAGR of 11.3 per cent. This gels quite closely with the earnings CAGR of 10.8 per cent over the entire period. The average dividend yield through this entire period has been around 1.35 per cent. The total return is therefore, about 12.5 per cent compounded for a broad buy-hold strategy. Broken up, the CAGR of price return for 2005-2008 was a fantastic 43.7 per cent, while price CAGR was negative for 2008-11 (-3 per cent) and also negative for 2011-present (-9.9 per cent).
The conclusion is inescapable. Despite huge volatility, prices and changes in earnings growth rates correlated well across this long period. Prices responded exaggeratedly to changes in earnings patterns. Until the earnings growth rate picks up again, it would be optimistic to expect the market to turn bullish in a sustained fashion.
The author is a technical and equity analyst
