Do company earnings drive the stock market or is it something else?

bullfightingAn interesting piece of analysis, which is carried out almost every time the quarterly results come out, caught my eye on January 26, 2015, in the Business Standard newspaper.
The combined net profit (adjusted for exceptional items) of 290 companies which have declared their results for the period between October to December 2014, grew by just 2.2% in comparison to the same period last year.
Interestingly, this set of companies had declared a profit growth of 12.6% during the same period last year and 9.8% during the period July to September 2014, the newsreport points out.
When it comes to the growth in revenues of these companies the results are worse. The combined sales of the 290 companies which have declared results fell by 4.4% in comparison to the same period last year. This is the first drop in eight quarters.
In fact, if banking and financial companies and IT exporters are taken out of this sample, the combined revenues fell by 11% in comparsion to the same period last year. The net profit fell by 4.8%.
These are not great numbers at all. While, the sample size may not be big enough it is a cause for worry nonetheless. Further, the projection on revenues growth isn’t great either. Crisil Research in a recent report said that it expects revenue growth of India Inc to “slip to a 6-quarter low of 7% on a year-on-year (y-o-y) basis in the December 2014 quarter.” “Revenue growth was around 9% in the preceding quarter and 13% in the December 2013 quarter,” Crisil Research pointed out.
Nevertheless, the stock market has continued to rally. Financial theory tells us that stock prices are ultimately a reflection of discounted future earnings of a company. But that doesn’t seem to be the case here. If the stock market was expecting quarterly results to be bad then it should have been falling, as per theory. But that doesn’t seem to be happening.
Having said that we are looking at data for just one quarter. How strong is the link between earnings growth and Sensex returns over the long term? Ambit Research has the answers in a recent research note titled
The Three ‘Stories’ That Drive the Sensex. As can be seen from the following table there is”no meaningful relationship between Sensex returns and earnings per share growth between financial years 1992-2014.”

No meaningful relationship between Sensex returns
and EPS growth between FY1992-2014

Source: Bloomberg, CEIC, Ambit Capital research

How do things look if we plot Sensex returns of a given year with earnings per share growth of the previous year? Again there is no meaningful relationship between Sensex returns and lagged earnings per share growth between financial years 1992-2013.

No meaningful relationship between Sensex returns
and lagged EPS growth between FY1992-2013

Source: Bloomberg, CEIC, Ambit Capital research

In fact, the relationship between Sensex returns and economic growth (measured in terms of GDP growth) is also not meaningful, the research note states. This is something that valuation guru Aswath Damodaran also told me a few years back when I had asked him:
“How strong is the link between economic growth and stock markets? “It’s getting weaker and weaker every year,” he had replied.
So what drives the Sensex? “Over the last 30 years, there has been a pronounced tendency for the Sensex’s returns to revert to the mean, with the mean being around 17%,” the Amit Research note points out (See the following table).

Rolling five-year Sensex return CAGR

Source: Bloomberg, CEIC, Ambit Capital research

Another very good predictor of Sensex returns is the political-economic cycle. “The Sensex seems to move in sync with India’s political cycle (which in turn seems to have a profound influence on India’s economic cycle). In particular, the Indian economy seems to move in 8-10-year economic cycles, with the beginning of these cycles coinciding with decisive General Election results (eg. 1984, 1991, and 2004). Then in the first three years of these economic cycles, the Sensex seems to appreciate sharply as investors discount the decade-long economic cycle. So, whilst the Sensex’s 30-year CAGR is 16%, its CAGR during the first three years of each of the economic cycles (1984-87, 1991-94 and 2004-07) is ~33%,” the Ambit Research note points out.

The remarkable synchrony between political and economic cycles in India

Source: CEIC, Ambit Capital research

These rallies stem from the Indian middle class’s hope of finding a strong leader and that in turn leads to the Sensex rallying for the next three four years. Using this theory we can say that the current Sensex rally will last till 2017-2018.
Also, for the past few years we have been living in an era where the narrative of central bank omnipotence holds. As Ben Hunt who writes the Episilon Theory Newsletter puts it:
central bank policy WILL determine market outcomes. There is no political or fundamental economic issue impacting markets that cannot be addressed by central banks. Not only are central banks the ultimate back-stop for market stability (although that is an entirely separate Narrative), but also they are the immediate arbiters of market outcomes. Whether the market goes up or down depends on whether central bank policy is positive or negative for markets.”
Over the last few years central banks of developed countries like the Federal Reserve of the United States, the Bank of England and lately the Bank of Japan have been running an easy money policy by printing money. The European Central Bank has become the latest central bank to join the money printing party.
While the Federal Reserve has stopped printing money in October 2014, the Bank of Japan and the European Central Bank are still at it. And this “easy money” has been driving financial markets all over the world. In this world, earnings and economic growth do not matter. What matter is how much money is coming into the stock market.

(The column originally appeared on as a part of The Daily Reckoning on February 4, 2015)