The Earnings Propaganda - Niederhoffer

oxusmorouz · #1 21st February 2008, 07:11 PM

The succeeding quote is taken from Niderhoffer's Practical Speculation. Looking for your opinion.

Quote:

The one thing that everyone, from the most uninformed layperson to the most erudite professor knows about the stock market is that earnings determine returns. Chapter 1 of every finance text book, lecture 1 of every investment class and every news dispatch all agree:
1) Earnings and markets move up and down together
2) The greater the earnings increases, the higher the market return.
3) When earnings are up, it is time to buy stocks, and when earnings are down, it is time to sell stocks
4) When the market’s price/earnings ratio is high, it is time to sell.

Analysis of each of these hypothesis’ would invalidate each and every one of them as false. Contradictorily, each is completely opposite to the actual empirical relations. Almost everything investors are taught about in relation to the earnings and stock markets returns, whether in business schools or on the stock market pages of the newspaper is wrong.

Shrewd articles know that they will not get far in life by relying on the conventional explanation of market moves. But the great majority of investors are deceived on both the big and the small aspects of this relation.

Firstly, it is necessary to examine the actual relations between earnings and the market returns. There are many different leads, lags and ratios to be tested. The best way to reveal these relationships is with a scatter diagram. If these data tend to life close to the line of best fit, then there is a strong relation. If the data tends to appear to lie In a shapeless mass around the line, then there is little or no relation. Each of the charts uses earnings data from S&P securities price index record, updated with current figures and returns data from London Business School’s comprehensive database of global markets.

According to the induction, stocks are supposed to go down when earnings are down and go up when earnings are up. In fact, they don’t and the opposite relation holds good.
1) If reported S&P 500 earnings rise in a year, the S&P 500 is likely to perform worse than average that year.
2) If the reported earnings fall in a year, the S&P 500 is likely to perform better than average that year.

The inverse relationship is shown in the above figure. Notice how the line of best fit slopes gently from the northwest quadrant to the south east. This is the hall mark of what statisticians call negative correlation. Regression analysis is used to calculate an equation that expresses this slightly inverse relation between earnings and next year’s market return as a line of best fit: S&P 500 return = 9.6 percent minus one fifth of the annual percentage change in the S&P earnings. The equation explains some 5% of the total variation in stock prices from normal. Another way of saying this is that if a person new nothing about earnings change in a year, the best forecast of S&P 500 returns in 2002 would be 9.6%. Knowledge of the earnings would increase the predictive ability of the analyst by only 5%

RSI · #2 21st February 2008, 07:18 PM

Is it because the market discounts the future and not the past? I would like to know what happened if the earnings are down continuously for several years and whether during all these years stock price went up? Or was it that stock price also went down along with downgraded earnings and took off just before the earning improved?
Thanks and regards

oxusmorouz · #3 21st February 2008, 07:30 PM

Hello RSI,

Quote:

Originally Posted by RSI

Is it because the market discounts the future and not the past?

If you rely on expected earnings, as the earnings are gradually disclosed, what predictive information does the already disclosed earnings (although estimated before) hold after the fact?
How often have we come across situations where the "analysts" forecast future sales growth (which usually forms the basis of any cost statement) is naively extrapolated from the past data rather than taking a zero based approach.

Quote:

Originally Posted by RSI

I would like to know what happened if the earnings are down continuously for several years and whether during all these years stock price went up? Or was it that stock price also went down along with downgraded earnings and took off just before the earning improved?
Thanks and regards

As I have mentioned already, the information quoted is not primary but merely taken from another source. If you are interested, perhaps taking data from the same source the author has taken would prove beneficial.

Regards.

kkseal · #4 21st February 2008, 10:30 PM

Earnings & mkt valuations (how much of that earnings is already factored into the price) have to be viewed together. Liquidity (linked to int rates) is another factor. Isolated viewing (Technically or Fundamentally) never works imo.

Regards,
Kalyan.

ravalsb · #5 22nd February 2008, 03:14 AM

Quote:

Originally Posted by oxusmorouz

The succeeding quote is taken from Niderhoffer's Practical Speculation. Looking for your opinion.

Is the author trying to justify inverse relationship between earnings and price?

May be this holds partially true. Suppose, a company is about to announce results in the month of April. Anticipation of good results may push prices up before the announcement and after the annoucement of results and subsequently it retraces.

I have expereinced this in IDEA, which I bought @ 134 on the date of Q2 results and then it retraced to 115-117 levels in next few sessions. It was only after few weeks that i could see break even. Since i hold it for long term there is no issue, but otherwise, good earnings actually resulted in fall in share price, eventhough for short period of time.

Please correct me if i am wrong.

Thanks & Regards