The Impact of Earnings on the Stock Market

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In the past, significant drops in S&P 500 earnings have had a profound impact on the stock market’s performance. Instances such as the 70% decline in earnings in 2008 and the 40% drop in 2001 led to significant corrections in the S&P 500. However, historical analysis reveals that not all declines in earnings result in a substantial decline in the stock market. Understanding the relationship between earnings decline, market performance, and the actions of the Fed is crucial for investors.

In this article, we delve into history to shed light on whether a drop in earnings in 2024 would lead to a significant stock market decline or if the market could continue to climb higher despite a recession.

Earnings Decline and Stock Market Performance

A look back at the past 80 years reveals around 13 instances where S&P 500 earnings declined by 20% or more, mostly occurring during recessions. While some of these instances led to substantial drops in the stock market, others did not result in any decline. Analyzing the factors that influenced these outcomes provides insights into the potential impact of earnings decline in 2024. For instance, despite earnings downturns in 1985 and 1990, the stock market saw remarkable rallies.

Interest Rate Cuts and Stock Market Valuations

When exploring historical episodes, it becomes evident that the actions of the Fed play a crucial role in shaping market performance. During periods when the Fed cut interest rates, stock market valuations often rose. Lower interest rates reduce the attractiveness of holding cash, prompting investors to allocate more capital to assets like stocks, thus driving up market valuations.

This phenomenon was observed during the recession of 1990, where valuations increased by around 100% as the Fed cut interest rates, allowing the stock market to continue rising despite a 30% drop in earnings.

Gradual Earnings Decline and the Importance of Valuations

To see a similar scenario unfold in the next recession, a gradual decline in earnings (or no decline) would be key. The stock market tends to react unfavorably to sharp drops in earnings, as they create uncertainty among investors. In addition, the Fed would need to cut interest rates in 2024, pushing market valuations higher. Currently, stock market valuations stand at a PE of 22, historically leaving room for a rise to around 30, as seen during the dot-com bubble and briefly in 2021.

Earnings Rise and Stock Market Decline

While history suggests that rising valuations during an earnings decline can support a market rally, there are instances where the opposite occurred. In 1974 and right after World War II, stock market earnings increased significantly, but the market experienced substantial declines.

The reason market valuations plummeted in 1974 was due to a surge in interest rates, which reached 13%. When the Fed raises interest rates, it starts making cash a more attractive option. In 1974, investors favored cash, yielding 13%, diminishing the attractiveness of stocks.

Over the course of the past six decades, there has been a consistent pattern whenever the Fed has decided to increase interest rates. This pattern has consistently led to a decline in stock market valuations. Even in the year 2022, when the Fed implemented rate hikes, there was a significant 25% decrease in stock market valuations, albeit from an elevated PE of 30.

Possibility of Additional Rate Hikes

If the Fed mirrors the 1970s pattern by raising rates beyond 5%, a significant market decline may occur, irrespective of potential earnings growth. The only way this could happen is if we see another wave of inflation. However, the historically reliable break even inflation rates currently don’t signal an imminent inflation surge.

The Fed has even suggested potential 2024 rate cuts, resulting in an equity rally as investors front-run these potential cuts. If valuations continue rising before a recession, then stocks would have no downside protection for earnings, given the big run up. Such an occurrence would be similar to the 2000 run-up followed by the 2001 recession.

Conclusion

Historical patterns indicate that gradual earnings decline, coupled with the Fed’s interest rate cuts, can lead to rising market valuations, enabling the stock market to continue climbing despite a recession. However, unexpected dynamics, such as rising earnings accompanied by a stock market decline, can occur when the Fed raises interest rates. While current valuations are high, the direction of future interest rate changes remains uncertain.