What drives stock dividends? Profits, right? So, what drives the dividend? potential economic growth. After all, it is difficult for companies to increase their sales and profits in a faltering economy.
However, the relationship between stock returns and economic growth is more illusion than reality. It might make sense, but there is little actual data to back it up.
For example, the Chinese economy has expanded at a consistent and impressive pace, around 10% annually, since 1990. This should have provided ideal conditions for Chinese stocks to thrive and generate attractive returns. But investing in Chinese stocks has not been a smooth ride. The Shanghai Composite Index has been rising since 1990, but the trajectory has never been flat, with multiple drawdowns of 50%.
This lack of correlation has a simple explanation. Historically, the Chinese stock market has been dominated by largely unprofitable state-owned enterprises (SOEs) and has not reflected a very dynamic economy.
But China is not far away. Elroy Dimson, Jay R. Ritter, and other researchers have shown that the relationship between economic growth and stock returns has been weak, if not negative, almost everywhere. They’ve studied developed and emerging markets across the entire 20th century and provide hard-to-refute evidence.
Their results indicate that the relationship often made between economic developments and stock market movements by equity analysts, fund managers, and the financial media is largely wrong.
But what about the dividends that pay dividends? Is this relationship still valid? After all, Finance 101 teaches that a company’s valuation represents future discounted cash flows. So let’s see if we can at least validate this connection.
Earnings vs stock returns
To explore the relationship between US stock market returns and earnings growth, we first computed five-year graded returns for both time series using data from Robert J. Schiller of Yale University more than a century ago. From 1904 to 2020, earnings growth and stock returns moved in tandem over certain time periods, however, there were decades where they diverged completely, as evidenced by a low correlation of 0.2.
The perspective does not change if we switch the window for calculating the rolling return to 1 year or 10 years, or if we use real, not nominal, stock market prices and earnings. The correlation between US stock market returns and earnings growth has been essentially zero over the past century.
US stock returns and dividends: five-year rolling returns
Perhaps the lack of a relationship between stock returns and earnings growth is because investors focus on expected growth rather than current growth. A company’s valuation is based on discounting future cash flows after all.
We tested this hypothesis by focusing on earnings growth for the next 12 months and assuming that investors are perfect predictors of US stock earnings. We treat them as excellent investors.
But knowing the earnings growth rate in advance wouldn’t have helped these big investors time the stock market. Returns were negative only in the worst tenth of the forward earnings growth percentages. Otherwise, whether the earnings growth rate is positive or negative has little effect on stock returns.
US Equity Yields: Next 12 Months Earnings Growth vs. Equity Yields, 1900-2020
Earnings growth vs. P/E ratios
We can extend this analysis by investigating the relationship between earnings growth and P/E ratios. Logically speaking, there should be a strong positive correlation where investors reward high-growth stocks with high multiples and punish low-growth stocks with low multipliers. Growth investors have repeated this mantra to explain the extreme valuations of tech stocks like Amazon or Netflix.
Again, the data does not support such a relationship. The average P/E ratio was indifferent to the expected earnings growth rate over the next 12 months. In fact, the higher forward growth to price-to-earnings multiples were slightly below average.
If the focus is on current earnings, our interpretation may be that an increase in earnings leads to an automatic decrease in the price-to-earnings ratio. But with forward earnings, these results are less intuitive.
US Equity Yields: Next 12 Month Earnings Growth vs. P/E Ratios, 1900-2020
Why do profits matter so little to stock market returns?
The simple explanation is that investors are irrational and stock markets are not perfect discounting machines. Animal spirits are just as important if not more so than the essentials. The tech bubble of the late 1990s and early 2000s is a great example of this. Many of the high rise companies of the era like Pets.com or Webvan had negative earnings but stock prices soared.
Does this mean that investors should ignore earnings completely?
A lot indeed. Millennials, in particular, have made big bets on GameStop, for example, and some hedge fund managers are pursuing momentum strategies. And while the former does not seem like a sound investment, the latter is a perfectly acceptable strategy that does not require any earnings statements.
So, while earnings should not be completely ignored, investors should not assume that they are the driver of stock returns.
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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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