Wednesday, August 28, 2013

Is There Risk in Equity Prices Outpacing Earnings Growth?

A number of recent articles from a host of finance news sources (I could list them but a simple google search should be adequate to find the better cited articles) have highlighted that the percentage change in the value of the S&P 500 has far outpaced the similar changes in earnings. The authors suggest that this adds to the risk that the market may correct in the near-term.

Looking at the objective data however, there appears to be little to no relationship between the difference in the change in value versus similar changes in earnings and the forward 12-month value in the S&P 500. I created the below chart using Robert Shiller's market data via his website.

 Source: Shiller Data

The above chart shows the relative difference of the 12-month change in value of S&P 500 earnings and the value of the stock market (diff) and relates this to the 12-month forward change in the value of the index. Negative relative changes in the diff should, if the exposed theory holds, indicate low or negative performance in equities and vice versa. Looking at the chart, some times the 'relationship theory' does seem to hold. However, in others no relationship is apparent. More so, the correlation and the R-squared calculations show little to no relationship between the diff and the forward 12-month change in stock prices.

I remain more bearish at the market due, in part, to abnormally high profit margins, the manipulation of QE, stalling economic growth, etc. I would have liked this supposedly concise model to suggest higher market risks, but the objective data state otherwise.

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