Earnings and the economy will set the path for the stock market


During market-shaking events, we would look to the path of earnings to get a sense of where equity market values are headed over the next few years.


March 2, 2022

Jim Allworth
Investment Strategist
RBC Dominion Securities

The chart below traces the path of the S&P 500 Index from the end of 1945 until today. It is plotted annually—that is, there is only one data point per year; one doesn’t see all the to-ing and fro-ing that goes on between each Jan. 1 and Dec. 31, rather just the value at each year-end.

While there are plenty of ups and downs, the rising trend of stock prices is clearly evident over the 76-year time span and remarkably consistent over 20-year stretches.

S&P 500 Index since 1945

S&P 500 Index since 1945

Since 1945, the S&P 500 has advanced in a well-defined uptrend.

The line chart shows that the S&P 500 Index has risen at a persistent, year-over-year pace on a trend basis from the end of WWII through 2021

S&P 500 Index


Source – RBC Wealth Management, Bloomberg; annual closing data through 2021

One can easily spot some of the most challenging bear markets—e.g., 1973–1974 where the accompanying recession turned much of industrial America into the “Rust Belt”; the “tech wreck” from 2000 to 2003; and the financial crisis collapse of 2008–2009. But it is surprising how many of the other bear markets over that stretch (there were nine of them), not to mention other momentous and memorable market-shaking events, are hard to see or outright invisible when looked at this way.

Consider the following:

  • The Korean War from mid-1950 to mid-1953, including the entry into the war of the Chinese Red Army.
  • The seven-month market-unfriendly stretch in 1962 starting with the Kennedy steel price rollbacks and finishing with the Cuban Missile Crisis.
  • The collapse of oil prices and much of the heavily indebted oil and gas sector together with the Latin American debt default/bailout saga that played out through the mid-1980s.
  • The 1987 market crash that sent a number of Wall Street firms into insolvency and prevented many investors from getting a good night’s sleep for a number of years afterward.
  • The savings and loan crisis that festered from the mid-1980s into the 1990s and saw about one-third of these institutions collapse, necessitating a massive government bailout of the industry, which at the time was the largest source of mortgage lending as well as a very significant deposit-taker in the U.S.
  • The Mexican government debt bailout of 1995.
  • The calamitous emerging market currency crisis that began in mid-1997 and featured some of the steepest weekly declines in share prices ever recorded. It morphed in 1998 into the Russian debt default and the collapse/bailout of Long-Term Capital Management.
  • The European sovereign debt crisis, which followed on from the financial crisis and wasn’t resolved until 2012.
  • The COVID-19 pandemic, which saw share prices plummet by a startling 31 percent in less than six weeks in 2020.

All of these are largely or entirely invisible on this 76-year chart of the S&P 500.

An investor usually only had to be patient for about a year as most market downturns resolved back into uptrends by that time. There were only two instances of back-to-back annual market declines: 1969–1970 and 1973–1974. And there was one three-year decline: 2000–2002. The latter featured a recession in 2001 induced by a credit crunch, the 9/11 attacks followed by the war in Afghanistan in the same year, and the slow-motion collapse into early 2003 of tech sector share prices in the wake of high-profile bankruptcies and accounting scandals. But markets had regained all the ground lost by 2006.

It’s no mystery …

The next chart again depicts the S&P 500 plotted annually over the same 76 years but this time with a simultaneous plot of S&P 500 earnings per share. Both are indexed to a starting value of 100 for easy comparison.

Annual S&P 500 Index and S&P 500 earnings per share since 1945

Annual S&P 500 Index and S&P 500 earnings per share since 1945

Share prices have risen with earnings. Since 1945, both stocks and earnings have risen 7.3% per annum.

The line chart shows the annual closing value of the S&P 500 Index and S&P 500 earnings per share (EPS) from 1945 through 2021. The two data series increase in parallel.

S&P 500 Index

S&P 500 operating EPS

Source – RBC Wealth Management, Bloomberg; annual closing data through 2021, indexed to 1945 = 100

As of today the race depicted here is pretty much a dead heat: since 1945 the S&P 500 has appreciated exactly as fast as the earnings per share of the index—both at close to 7.3 percent per annum. (Of course, shareholders did better than that collecting dividends along the way equal to about two percent per annum on top of the appreciation return.)

Earnings and share prices didn’t move in lockstep. Sometimes earnings were growing faster than share prices were appreciating, while at other times it was vice versa. But both were rising on a trend basis. And for the most part, when earnings were rising so were share prices, while earnings declines more often than not were accompanied by falling share prices.

It doesn’t seem a long leap to conclude that if an investor wants to get a handle on where the value of the S&P 500 is headed over the next few years, they should seek out a reliable forecast of what path earnings per share will follow over that period.

Do earnings rise by magic?

No. They rise at a rate mostly consistent with the growth rate of the economy, a relationship depicted in the next chart, which plots the earnings per share of the S&P 500 at the end of each year alongside the value of U.S. GDP produced in that same year. (This is the so-called “nominal” value, that is, with the effect of consumer price increases left in.)

Annual S&P 500 earnings per share and U.S. nominal GDP since 1945

Annual S&P 500 earnings per share and U.S. nominal GDP since 1945

Over the past decade, earnings have risen somewhat faster than the economy has grown!

Since 1945, earnings have increased 7.3% per annum and the nominal GDP has increased 6.3% per annum.

The line chart shows the change in annual S&P 500 earnings per share and the U.S. nominal GDP since 1945, indexed to 1945 = 100. Earnings per share has increased somewhat faster than GDP over the period shown.

U.S. nominal GDP

S&P 500 operating EPS

Source – U.S. Department of Commerce, Bureau of Economic Analysis; annual closing data through 2021, indexed to 1945 = 100

This GDP plot is incredibly smooth. Despite the fact there were 12 recessions over the interval from 1945 to today, fewer than half show up as no more than faint ripples in this steadily rising line. The rest can’t be seen at all.

While the accompanying earnings per share plot is much bumpier, for the most part it hugs the trend traced out by the economy. However, one can see that a growth gap in favour of earnings over GDP has opened up in the years following the financial crisis. Part of this is explained by the big Trump corporate tax cut in 2017, which boosted average after-tax earnings by an estimated 12 percent.

There is at least one additional explanation. In recent years, particularly in the recovery from the pandemic-driven recession, some of the companies accounting for the biggest capitalisation weights in the S&P 500, notably large-cap tech and tech-related, have seen their foreign earnings surge higher. This has boosted index earnings per share but not U.S. GDP to the same degree.

There is debate about whether some of these companies are behaving monopolistically. If they are found to be, then some of these profits may suffer under antitrust enforcement. The EU has indicated it is prepared to take an aggressive stand on this, and the Biden administration appears likely to be more activist as well.

If these are shown not to be monopoly profits then some portion should eventually be competed away. Whether it’s by enforcement or competition, it will take some time to see any impact on profitability.

The valuation question

Are stocks, in this case the S&P 500, overvalued? Since the end of 2009, when the worst of the financial crisis had been left behind and the recovery from recession had begun, to the end of last year the S&P 500 appreciated at a rate of 12 percent per annum while the earnings per share of the index grew by a startling 15.5 percent per annum. So if anything, it has been earnings that have been the overachievers here more so than average share prices.

And, as depicted in the chart, over the much longer 76-year postwar era, both earnings and share values have more or less moved along at the same 7.3 percent per annum average pace, well supported by the nominal growth rate of U.S. GDP and augmented by the even faster growth of the global economy outside the U.S. in which many American companies have been active participants.

No big value gap has opened between share prices and index earnings as happened in the two years leading up to the peak of the tech bubble. Price-to-earnings (P/E) multiples tell much the same story. At its highs in December, the S&P 500 was trading at 21x the forward 12-month consensus earnings per share estimate. The pullback has brought that down to 18.6x forward earnings of $228. That’s only moderately above the 30-year average forward P/E of 17.4x.

Major markets outside the U.S. are even cheaper. Canada’s S&P/TSX Composite Index at 14.1x forward earnings estimates is below its historical average of 14.8x and at one of the deepest P/E discounts relative to the U.S. in history. European, UK, and Japanese markets are trading at comparably low or even lower multiples.

For us, valuations do not pose a large risk to investors as things stand. In our view, it would take a serious deterioration in the earnings outlook to push the market into a state of overvalued vulnerability. Such a deterioration would likely show up ahead of time in the leading indicators of recession. Our U.S. recession scorecard is showing no such weakness.

U.S. recession scorecard

The scorecard shows seven economic indicators and the current status of each as either expansionary, neutral, or recessionary. All seven have an expansionary status. The indicators are: Yield curve (10-year to 1-year Treasuries); Unemployment claims; Unemployment rate; Conference Board Leading Economic Index; Free cash flow of non-financial corporate business; ISM New Orders minus Inventories; Fed funds rate vs. nominal GDP growth.

Indicator Status
Expansionary Neutral Recessionary
Yield curve (10-year to 1-year Treasuries)
Unemployment claims
Unemployment rate
Conference Board Leading Economic Index
Free cash flow of non-financial corporate business
ISM New Orders minus Inventories
Fed funds rate vs. nominal GDP growth

Source – RBC Wealth Management

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Jim Allworth

Investment Strategist
RBC Dominion Securities

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