BY: Robert Strauss, CFA®
Senior Portfolio Manager, Argent Trust
When discussing investment management strategies with clients, one thing I stress is that earnings, or after-tax corporate profits, drive equity performance and, ultimately, the overall market. As we embark on the potential full economic recovery and subsequent resumption of growth in a post-pandemic world, we anticipate possible positive movement of the equity markets because of growth in corporate earnings – though most likely at lower than the recent historical returns.
Given that backdrop, Argent’s Asset Allocation and Strategy working group decided to make an allocation change in February (led by a recommendation from the Equity Strategy working group). The group elected to increase our equity percentage and subsequently reduce fixed income exposure in Growth & Income portfolios to take advantage of the current environment. Simply put, we believe that earnings growth for global companies is set to accelerate, and that renewed optimism could lead to increases in business activity, enhanced by the continued impact of fiscal stimulus. The improving economy has made bonds less attractive as an investment compared to equities. We are continuing to see the fruits of this development as we have seen positive earnings results in the first quarter reporting season.
There is an adage that, in my opinion, still holds true even in today’s equity markets: “As earnings go up, stocks go up. If earnings go down, stocks go down.” It’s a simple concept, but one that carries a lot of weight over the long run. Earnings estimate revisions and surprises are continuing to move upwards (greater than 23% this quarter!), whereas the typical pattern of estimate revisions tend to start high, move down until expectations normalize and then eventually resume upwards. Due to this nuance, history does show some volatility throughout each annual year.
In their groundbreaking report of earnings and stock prices published in the Journal of Accounting Research in 1968, Ray Ball and Philip Brown proved this concept. In the period after earnings are announced, stock prices continue to move in the same direction as the just reported change in year over year earnings. The study was based on 261 firms for the nine-year period from 1957 to 1965 – and 50 years later the findings continue to show merit.
The notion of stock prices moving in the same direction as earnings changes after the earnings are announced is known as the post-earnings announcement drift. If this pattern continues, based on the most recent reported results, the earnings estimate for 2023 could end up being the actual results for 2022. How exciting would that be!
Investment management tactics for today’s market
A popular question we receive today from clients is “When will the market stop moving higher or reverse course?” Well, that is a loaded question. Bear markets typically happen when recessions are around the corner. We tend to believe that labor market trends, which drive economic activity, are a good barometer of things to come. History, which is not a guarantee, does show a strong correlation between lower unemployment and a higher price for the S&P 500 and vice versa. Thus, if unemployment deteriorated, earnings, broadly speaking, are likely to reverse course and equity markets would likely also reverse course. A possibly oversimplistic idea, but keep in mind the previous adage, when earnings go up, stocks go up and vice versa. Argent’s Equity Strategy working group monitors that key data point every two weeks along with many other economic items. We also recognize that predicting a recession is quite the impossible task.
So how do we manage the eventual future correction in equity markets? We do it by making sure our clients have the most suitable investment objective and time horizon, maintaining valuation discipline, rebalancing regularly, and taking advantage of the equity market volatility when it is presented to us. It is a time-tested investment management concept that has proven to work in both good times and in volatile times for creating and sustaining wealth for our clients over multiple generations.
