Daily Equity Report

Over the long term the key driver to market returns is earnings growth. Shorter period returns can be dictated by the varying states of investor psychology, from over exuberant to overly pessimistic, but ultimately company earnings drive stock market returns. The chart below shows that these two variables track each other over the longer term, but also that they don’t track each other exactly. It therefore follows that investor returns will be dictated, to a large extent, by the growth in earnings and the initial price paid on the earnings.

Earnings (and by extension dividends) are far more stable than market movements as a result of investor psychology. Investors typically overreact to news (and expected news) and therefore by the time investors expect an earnings drop the share price (remember markets are forward looking) will in all likelihood have fallen by more than the expected drop. The chart below shows the relative drawdown of the market compared to the composite earnings drawdown of the companies listed on the JSE Securities Exchange.

It is evident from the chart above that the market falls by more than earnings when earnings drop significantly. The graph also shows how the market is forward looking in that it falls before there’s a collapse in earnings. This lag has typically been around one year, but it can vary. Another interesting aspect is that large market corrections don’t always occur on the expectation of a drop in earnings. The crashes in 1987 and 1998 are two specific cases of this happening.

The large rally that started at the beginning of March last year has ensured that the market has moved back into expensive territory. While markets may continue up over the shorter term, patient investors will reduce their equity exposure and sit on the sidelines until attractive valuations once again present themselves.

Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966