Stocks Set For Multiple Contraction In 2021

Earnings & Stock Price Mismatch

EPS growth and stock prices don’t always match if you’re looking at data by year. As you can see from the table below, in 3 out of the 7 years EPS fell, stocks were up. In 5 of 9 times the stock market fell, EPS growth was positive. We will likely see very strong stock price growth and weak returns in 2021.  

If you take a longer-term approach, you can see the relationship between EPS and returns better. One inkling is to believe optimism about a cyclical recovery causes stocks to rise as earnings are falling. When earnings are strong, sometimes it’s tougher to have solid growth.

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The chart shows EPS growth went on a few runs of double-digit gains. 10 out of 16 times S&P 500 EPS growth was double digits, it rose 10% or more again the next year. Sometimes investors sell stocks because they are scared of a negative catalyst that ends up not causing as much damage as expected. 

For example, investors sold stocks before the 2020 election. That wasn’t enough to make the year negative, but it’s just an example. The selling at the end of 2018 made the year negative. It caused the Fed to get more dovish, which helped set the scene for 3.6% EPS growth in 2019 which isn’t that bad. The stock market’s decline actually had a positive impact on earnings in that scenario.

Expectations determine stock prices more than earnings themselves. Of course, if a company’s results are different from expectations, reality usually takes control. In that situation, there is a re-rating. That’s when investors take a new look at the company which causes its stock price to change rapidly. The stock market has largely been increasing since 1989 which is why the table shows there were 21 years of multiple expansion and only 11 years of contraction.

In 6 of the 11 years of contraction, stocks were up because EPS was up more. This year had the greatest multiple expansion ever at 51.2%. The 2nd best was in 1991. There were 3 straight years of multiple contraction following 1991. We will likely see this again in the next few years. And we could see a 20% EPS gain and a 5% decline in the index in 2021.

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