Trader’s Narrative

Guest Post by Vadim Pokhlebkin

It’s corporate earnings season again, and everywhere you turn, analysts talk about the influence of earnings on the broad stock market:

• US Stocks Surge On Data, 3Q Earnings From JPMorgan, Intel (Wall Street Journal)
• Stocks Open Down on J&J Earnings (Washington Post)
• European Stocks Surge; US Earnings Lift Mood (Wall Street Journal)

With so much emphasis on earnings, this may come as a shock: The idea of earnings driving the broad stock market is a myth.

When making a statement like that, you’d better have proof. Robert Prechter, EWI’s founder and CEO, presented some of it in his 1999 Wave Principle of Human Social Behavior:

Are stocks driven by corporate earnings? In June 1991, The Wall Street Journal reported on a study by Goldman Sachs’s Barrie Wigmore, who found that “only 35% of stock price growth [in the 1980s] can be attributed to earnings and interest rates.” Wigmore concludes that all the rest is due simply to changing social attitudes toward holding stocks. Says the Journal, “[This] may have just blown a hole through this most cherished of Wall Street convictions.”

What about simply the trend of earnings vs. the stock market? Well, since 1932, corporate profits have been down in 19 years. The Dow rose in 14 of those years. In 1973-74, the Dow fell 46% while earnings rose 47%. 12-month earnings peaked at the bear market low. Earnings do not drive stocks.

And in 2004, EWI’s monthly Elliott Wave Financial Forecast added this chart and comment:

Earnings don’t drive stock prices. We’ve said it a thousand times and showed the history that proves the point time and again. But that’s not to say earnings don’t matter. When earnings give investors a rising sense of confidence, they can be a powerful backdrop for a downturn in stock prices. This was certainly true in 2000, as the chart shows. Peak earnings coincided with the stock market’s all-time high and stayed strong right through the third quarter before finally succumbing to the bear market in stock prices. Investors who bought stocks based on strong earnings (and the trend of higher earnings) got killed.

So if earnings don’t drive the stock market’s broad trend, what does? The Elliott Wave Principle says that what shapes stock market trends is how investors collectively feel about the future. Investors’ mood — or social mood — changes before “the fundamentals” reflect that change, which is why trying to predict the markets by following the earnings reports and other “fundamentals” will often leave you puzzled. The chart above makes that clear.

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Robert Prechter, Chartered Market Technician, is the world’s foremost expert on and proponent of the deflationary scenario. Prechter is the founder and CEO of Elliott Wave International, author of Wall Street best-sellers Conquer the Crash and Elliott Wave Principle and editor of The Elliott Wave Theorist monthly market letter since 1979.

A reader, Wayne Whaley, who is also a veteran trader and registered CTA sends in this concise report on the earnings season:

“About 1/2 of second quarter earnings are in and we have a pretty good estimate now of what final earnings should look like at the end of the quarter.

With interest rates at current levels, you can make a mathematical case for P/Es in the 25-30 range

Observations:

Including the 2009 Second Quarter Estimate of 7.27, and using 979.26 as current S&P price

1) The P/E using last 4 quarters for E is 771.07
2) The P/E using last 8 quarters annualized for E is 37.21
3) The P/E using Standard & Poors estimate for 2009 earnings as E is 32.67
4) The P/E using Standard & Poors estimate for 2010 earnings for E is 26.28
5) Earnings for the third quarter need to come in around $8.50 to avoid a negative trailing one year earnings, which from the information I have would be a first (at least in the last century).

At best, you could argue that stocks are fairly valued even using estimates for 2010 earnings. Valuation techniques are interesting to calculate and make for interesting conversation but can be misleading for market timing purposes as the market can be over (1995-2000) or underpriced (1950’s) for years, especially when earnings and money supply are moving targets.”

The chart below provides perspective on the earnings collapse by focusing on 12-month, as reported S&P 500 earnings. This quarters earnings are expected to have fallen over 98% since topping in the third quarter of 2007. That makes this, by far, the worst decline on record all the way back to 1936 - the earliest we have data. In fact, real earnings have dropped so far that in the coming quarter will see the first 12-month period where the S&P 500 earnings are actually negative!

Source: Chart of the Day

While this is certainly makes for a great story that we can tell and retell to the grandkids (boring them to tears), it doesn’t really mean much. We are at an extraordinary moment in economic history. One where we are clinging to the ledge by our fingernails and peering down at the precipice below. In such unorthodox times, orthodox measures such as the price earnings ratio can fool, rather than inform you.

For economic and market news and to see what you may have missed last week, check out the list below. It is a small sample, to see it all go to news.tradersnarrative.com:

• Doug Kass: The Roubini Top?
• What went wrong with economics
• The real price of Goldman’s giganto-profits
• Get a FREE Subscription to Financial Magazines
• SEC’s Wish List
• Top Rated Technical Analyst: Market Range Bound
• Matching the Time Frames of Your Analyses and Your Trading
• The ABC’s of CDOs
• Get in on EWI’s FreeWeek for Commodities (only until July 22nd)
• Shadow Banking: What It Is, How it Broke, and How to Fix It
• A Tale of Two Bailouts
• Dissecting a Pro’s Portfolio
• Toxic Equity Trading Order Flow on Wall Street

For the complete list, follow the graphic below:

And remember to check back regularly since there are interesting links added throughout the week.

Earnings Season:

If it is one thing that this bear market has delivered, it is superlatives. Indicator after indicator, metric after metric has gone off the charts and rendered any historical comparison useless. Earnings data seems to be the latest of these.

Earning season is mostly over and although historically the market weakens during this time, we seem to have evaded any serious repercussions (at least so far).

The magnitude of the economic collapse, as shown in the aggregated earnings of the S&P 500 Index is frightening. The chart below, from Chart of the Day, shows 12-month, as-reported S&P 500 earnings. With almost all earnings reports in, over the past 20 months, this has fallen over 90%.

Keep in mind that this is showing real (or inflation adjusted) earnings. If current estimates are confirmed, towards the end of the year, we may see the first 12 month period with negative S&P 500 earnings!

While this is alarming, keep in mind that the market looks ahead while earnings are in the rear-view mirror. I tried to confirm the above chart by using Prof. Shiller’s data but the latest earnings data he shows is for December 2008. Using that as a starting point and going back 20 months, earnings are down 82% - which would lend credence to the 90% collapse.

But the chart doesn’t go back to the 1920’s to show whether the earnings collapse compares in a meaningful way to that era. So I used Shiller’s data once again to do that, here is how earnings looked back then (mouse over for details):

Although there was a dramatic decline from the high in late 1916 and once again a high in 1929, there was no 20 month period which can compare to the recent data. What we saw was an utter and complete collapse of earnings, the likes of which we’ve never seen.

To catch up on what you missed and to prepare for next week, here are just a few picks from the past week’s reading list at news.tradersnarrative.com.

• “Dumb Money” by Daniel Gross (look forward to Ritholtz upcoming book)
• US Tax Burden Near Historic Low (what? didn’t hear you, too busy teabaggin’)
• Get a 120 page report FREE from Global Market Perspective (limited time offer)
• David Tice: S&P 500 set to plunge 62% - that’s a real bear!
• Cramer attacks Jon Stewart for ambushing him
• Get a Free Subscription to Futures Magazine
• Yale economists discuss the financial crisis & Geithner’s response (must see video)
• Why we should have not only saved Lehman Bros. but invaded it.
• Warren Buffett’s investment in a Chinese electric car company
• Where in the World is Paul Volcker? and why is he so quiet?

Follow the link below to get much, much more:

And remember to check regularly since there are new links added everyday.

Week Ahead: US Results, Data Dominate