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) and Valero Energy ( VLO) 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.
Ned Davis Research analysts said in the report that their work shows that only one fundamental factor shows a clear and compelling relationship with stock prices, and that is the rate of inflation. In the 49% of the years when inflation, as measured by CPI, has been clocked at greater than 3.5%, the report said, stock market returns have been subpar at 3.9% per year. When inflation has been less than 3.5%, returns have rocketed at a 9.8% annual pace. This may explain the apparent mismatch between recent earnings and market performance. Although so-called core inflation has been measured at a 2% annualized rate this year, inflation as measured by the consumer price index is coming in at 4.2%. The bad news, according to Ned Davis Research, is that when actual CPI is greater than core CPI, the Dow Jones Industrials have risen just 2.7% per year since 1958, vs. 11% when overall inflation is lower than core inflation. The bottom line, according to the researchers, is that lower inflation, not higher earnings, is the key to future stock returns. If the relationship holds up, investors should therefore be less jubilant about the potential for solid returns in 2006 based simply on the prospect for continued earnings gains. Instead, they should worry about the Federal Reserve's efforts -- ineffective, so far -- to quell the past year's upside breakout in inflation.