Finance 101 is that earnings matter. But as we all know, what matters is which earnings you use? Along with the debates around the usefulness of acronyms like EBITDA, there are also endless debates around forecasted earnings. Useful or just the imagination of frenzied analysts? Liberum’s strategist Joachim Klement highlights a fascinating paper by Andrei Shleifer and his colleagues
This highlights work by the behaviouralist school of economics by looking at the deviations from fundamentals-based on analyst expectations for earnings growth and future stock market returns.
According to Klement one of the key findings “is that the variation in valuation measures like the P/E-ratio is driven by two factors: the difference between expected earnings and realized earnings and the difference between expected fair value and fair value after realized earnings. What has practically no influence on valuation measures is the expected return next year or over the next decade.”
Looking at that first driver – the difference between earnings and realized earnings – the key measure is faulty forecasts of future earnings. “ It turns out that next year’s earnings or the earnings in the subsequent years aren’t relevant. What drives deviations from fair value more than anything else (by a factor of ten more than near-term earnings forecasts) are long-term expected earnings growth”.
This analysis suggests that investors should pay close attention to long-term expected earnings growth.
In the chart below Klement shows the situation for the United States (S&P 500) as well as Europe (Stoxx Europe 600) today in comparison to historical data as far back as he could find it.
“According to the research by Shleifer, what matters is not the level of expected long-term earnings growth but the change. If analysts upgrade their long-term earnings growth expectations, that is typically followed by rising valuations and lower returns over the subsequent one, three, and five years. When analysts reduce their long-term earnings growth expectations, this is followed by lower valuations and higher equity returns. And what we observe today is that long-term earnings growth expectations in the United States are rising while those in Europe are falling. The difference between the two regions is small, so one should not make too much of it, but at least we can say that investors in the United States are pricing in more and more optimistic scenarios for the future, while investors in Europe are not.”
Tricio’s chief economist John Calverley has been musing on what’s happened to all the missing workers. The chart below – from the US Fed – shows the percentage of the working-age population in the US labour force, i.e., employed or looking for a job.
“It fell in the 2010s partly because of a lack of jobs. People gave up looking. The Covid-19 recession caused another sharp drop in participation, which is hardly surprising. What is surprising is that the participation rate is still so low a year on. Some 3-4 million workers are ‘missing’ despite job vacancies running at 10.4mn, well above the normal 7mn level. This matters because if they don’t come back soon the labour market will overheat and wage inflation will take hold, forcing the Fed to raise rates quickly. The hope is that the missing workers are just taking their time. They know there are plenty of jobs when they are ready and perhaps they are still worried about catching Covid-19. Meanwhile, with the help of enhanced unemployment benefits, the ban on rental evictions and the suspension of student loan payments, they have plenty of savings. Once they run down their savings, they will take a job. The worry is that too many will retire early or stay at home for good after experiencing the leisure of recent months and getting used to spending less on going out. “