NerdWallet Analysis: How Much Do Short Term Earnings Really Impact Stock Prices?

shutterstock_122929300

It’s the middle of earnings season, and the Q4 earnings reports continue to trickle in every day this week.  As Google (GOOG) stock spikes and Apple (AAPL) stock plunges, how much should investors be worrying about the earnings season rollercoaster on their brokerage accounts?  What lies in store for 2013 growth?

In early January, the Wall Street Journal ran an article pointing out that in 2012 the S&P 500 gained 13.4% – compared to only 1.3% growth in companies’ operating earnings in 2012. The implication is that returns came from unsustainable sources such as the Quantitative Easing stimulus programs by the Federal Reserve.

This prompted us to ask the question: how much do company earnings numbers in the short run really affect stock prices?

NerdWallet investigated earnings data going back to 1988 to find rather surprising results.

The Theory Behind Earnings

It is widely accepted among fundamentals-based investors that a company’s earnings are a key driver of its share price – and over the long run they certainly are. To see why, imagine that we have a large mature company called Macrosoft. Macrosoft recently had a fantastic quarter, resulting in EPS (earnings per share) of $8 instead of the $5 expected by the market. Because Macrosoft is mature, it doesn’t have any new investment opportunities for its additional $3 in earnings. Consequently, it will likely pay it out as a dividend or stock repurchase. As a Macrosoft shareholder, you are now receiving that additional $3 per share, increasing the total gross value of your holdings.

For a company that is not yet mature, the logic still holds. The only difference is that the company payouts are assumed to be at some point in the future. Additional earnings received now are used for investment opportunities that increase the overall value and size of the firm, allowing it to generate even more earnings in the future. The prospect of higher earnings means larger cash flows to you, the shareholder, once the company matures and runs out of profitable investment opportunities. As a result, you would be willing to pay more for the stock now than you would if it had lower expected earnings.

The Reality of Stock Price Fluctuations Around Earnings Season

In practice, however, our analysis showed that company earnings are not strongly tied to short-term stock price variation around earnings season, as one might have expected.

Specifically, the relationship between sequential growth in actual quarterly operating earnings of companies in the S&P 500 and the respective quarterly return of the index has been very weak going back to 1988 (data from Standard and Poor’s website). The correlation coefficient of this same-period comparison was only 0.20, which indicates a very weak relationship. Statisticians typically consider values from 0.00 to 0.30 to be weak, 0.31 to 0.70 to be moderate, and 0.71 to 1.00 to be strong.

Two data points from Q4 2008 and Q1 2009 were removed due to outlying values.

 

 

 

 

 

 

 

 

Next, since many people claim that the stock market is forward-looking, we considered introducing a “lag” factor into the operating EPS growth numbers. A lag factor of 2, for example, would compare the actual operating earnings from Q3 2010 to the S&P index return in Q1 2010. This would test for whether or not stock returns in a given period are in response to operating earnings two periods (quarters) into the future.

A negative lag factor would test to see if the S&P reacts in response to prior period earnings:

Operating EPS Growth vs. S&P 500 Return

EPS Variable Lag (Qtrs.)

Correlation Coefficient

R2

-4

0.09

0.01

-3

0.00

0.00

-2

0.20

0.04

-1

0.03

0.00

0

0.20

0.04

1

0.20

0.04

2

0.17

0.03

3

-0.12

0.01

4

-0.10

0.01

R2 is the coefficient of determination, or the correlation coefficient squared and is another measure for the strength of the linear relationship between two variables.

When we account for the possibility that stock market performance is looking forward into future earnings or backward at past earnings, the relationship is similar to – if not weaker than – the same-period data. This suggests that in general, actual company earnings are not a strong driver of stock returns in the short term.

Indeed, stock prices generally do not move in close conjunction with actual earnings results in the short term.

Takeaways for Investors

While short term indicators like earnings news releases clearly define the tone of trading for daily and weekly movements, investors with monthly or yearly time horizons should focus on earnings and performance patterns over far longer timeframes to make smart investment decisions – not just a snapshot in time.

In general, investors should be wary of placing too much weight on short-term factors like quarterly earnings when making investment decisions.  Earnings are a critical factor in assessing the long term potential of any company – but short term price variations should not, alone, be enough to scare off or win over savvy investors.  The moral to the story?  Stay calm when it comes to day to day changes.

Statistical Considerations

On a statistical note, using a simple linear correlation is an approximation for the true relationship between two time series such as these. The real relationship might not be linear, or there may be other statistical factors to take into account. However, the findings here are extreme enough that we can be fairly certain some small adjustments would not change the overall conclusion.

Disclaimer: The views and recommendations in this piece are held by the individual contributor and do not necessarily reflect the opinions of NerdWallet.

By Jonathan Hwa, Guest Contributor.