Earnings (Don't) Drive the Stock Market

Investors learn early on that earnings drive stock prices. Yet recent events, as well as some new analyses of the past five decades of financial history by Ned Davis Research, call the conventional wisdom into question.

Let's start with the past two weeks, which were the peak for the third-quarter earnings season. A little more than half of the companies in the S&P 500 and three-quarters of the Dow Jones Industrial Average reported their income during the period. As a group, they were outstanding, with Citigroup (C Quote) and Valero Energy(VLO Quote) just two examples of the impressive results.

According to Thomson Financial, the S&P 500 companies' "blended" growth rate -- which combines actual numbers for companies that have reported and estimates for ones that have not -- has been clocked at 16.1%. That's better than the 15.1% growth expected at the start of the quarter, and it represents the ninth consecutive quarter of double-digit earnings growth. Of the 341 companies that have reported this quarter, 68% were above analyst expectations, 13% were in line and 19% were below, according to Thomson. That compares favorably with a typical quarter, in which 59% of companies beat, 21% match and 20% miss.

Given all this strong earnings news, you would think that the stock market would be rockin' this month. Yet the S&P 500 lost 1.65% in October despite last week's rally and Monday's advance, while the Russell 2000, a measure of small companies, was down 3% for the month. For the year, they are down 0.3% and 0.6%, respectively, as of Monday's close.

Why the mismatch? In a report published late last week, Ned Davis Research says it's because, well, earnings don't drive stock results -- and never have. Quite the opposite.

The report says that in the 53% of the years since 1958 that S&P 500 earnings growth has been above trend (greater than 6% annualized), stock market returns have been just 3.9% per year. When earnings growth has been below trend, in contrast, stock returns have averaged 8.1% per annum.