Stock prices and earnings disconnected

David MoonBlog

by David Moon

The NASDAQ Composite finally caught up with the Dow Jones Industrial Average and S&P 500, hitting multiple new highs in the past couple of weeks. The index records have some investors celebrating, some cautious and some outright concerned.

They are all right.

As someone whose business involves, to a large extent, owning shares of stock, record high stock prices is a good thing, both for our firm and our investors. But current index levels are vulnerable because of their disconnect from underlying fundamentals. Not all investors agree.

“Technical investors” believe that stock prices adhere to the laws of inertia and momentum, not the financial constructs of earnings and other fundamentals. Technicians see record high stock prices as precursors to even higher records. Technical analysis is concerned only with the historical price movement of a stock, not the underlying business and its profitability.

For anyone who believes that stock prices are somehow related to the companies whose ownership the shares represent, there is reason for caution. Not panic. Prudence.

It is tempting to dismiss underlying business fundamentals as having any relationship, much less causal, with stock prices, because in the short-term they seldom do. Stock prices over a period as short as weeks or even months (and extreme cases, years) bounce around for an infinite number of possible reasons, only rarely related to corporate earnings. The S&P 500 has increased 22 percent in the past 18 months, although overall corporate earnings have been flat.

Yet the most correlated finance series with stock index levels is underlying earnings.

If you need some visual proof, go to The Google and search for “S&P 500 earnings history chart.” You’ll find a MacroTrends chart on which several things are obvious. Earnings and stock prices are related. The chart doesn’t prove that either is the cause of the other, but one cannot deny there is a remarkable relationship between the two. It is also obvious that stock prices and earnings do become disconnected from time-to-time, sometimes significantly. But if you are a long-term investor, price and earnings eventually converge, providing the most predictable clue to future stock prices.

My current cautiousness about the stock market is a function of earnings—specifically as they relate to stock prices.

In the past five years the S&P 500 increased 76 percent, despite only a 9 percent increase in the earnings of the companies comprising that index. Expanding prices and lagging earnings have resulted in a P/E ratio of the median New York Stock Exchange company that is not just higher than its historical average, it is currently an all-time high.

P/E ratios are tools of measurement, not prediction. But the euphoria of all-time high stock prices should be accompanied with a degree a caution.

David Moon is president of Moon Capital Management. This article originally appeared in the USA TODAY NETWORK.