With Their Back to the Future

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With Their Back to the Future

Postby Jonathan Nitzan » Fri Apr 06, 2018 11:06 am

WITH THEIR BACK TO THE FUTURE: WILL PAST EARNINGS TRIGGER THE NEXT CRISIS?
by Shimshon Bichler and Jonathan Nitzan [1]
Working Papers on Capital as Power. No. 2018/01. April. pp. 1-14. http://bnarchives.yorku.ca/534/

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[Illustration by Elvire Thouvenot-Nitzan: elvirethouvenot.com]

1. Why is the Stock Market Tanking?

The U.S. stock market is again in turmoil. After a two-year bull run in which share prices soared by nearly 50 per cent, the market is suddenly dropping. Since the beginning of 2018, it lost nearly 10 per cent of its value, threatening investors with an official ‘correction’ or worse.

As always, there is no shortage of explanations. Politically inclined analysts emphasize Trump’s recently announced trade wars, sprawling scandals and threatening investigations, as well as the broader turn toward ‘populism’; interest-rate forecasters point to central-bank tightening and china’s negative credit impulse; quants speak of breached support lines and death crosses; bottom-up analysts highlight the negative implications of the Facebook/Cambridge Analytica debacle for the ‘free-data’ business model; and top-down fundamentalists indicate that, at near-record valuations, the stock market is a giant bubble ready to be punctured.

And on the face of it, these explanations all ring true. They articulate various threats to future profits, interest rates and risk perceptions, and since equity prices discount expected risk-adjusted future earnings, these threats imply lower prices.

But there is one little problem. Unlike their pundits, capitalists nowadays tend to look not forward, but backward: instead of matching asset prices to the distant future, they fit them to the immediate past.

2. With their Back to the Future

Judging by Figure 1, the main driver of U.S. stock prices is current earnings per share, or EPS. [2] The chart contrasts monthly data for EPS and share prices since 1995. The top panel plots the levels of the two variables, while the bottom panel shows their annual rates of change, and in both cases the temporal pattern leaves little doubt: share prices and current earnings are tightly correlated.

fig_01a_p_and_eps_us_2panes_1995_on.jpg
fig_01a_p_and_eps_us_2panes_1995_on.jpg (236.19 KiB) Viewed 108 times


Before we proceed, it is worth noting that ‘current’ earnings are not exactly current: the EPS for a given month are earned not during that month but up two years earlier. The reason is twofold. First, each EPS observation is a 12-month trailing average of previously reported earnings. And second, each of these previously reported earnings represents profits earned in the previous year. All in all, then, each EPS observation covers 12 to 24 months’ worth of profits, so if stock prices are indeed driven by EPS, they are driven not by current profits, but by past ones.

These considerations have two implications. The first and less important is that, contrary to popular belief, the recent market trajectory – i.e., its increase till December 2017 and its drop since February 2018 – has had little to do with President Trump. As the chart shows, when Trump took office in January 2017, prices were already rising on the back of an EPS recovery that started in November 2015 (marked by the first vertical dotted line). EPS growth accelerated after Trump entered the White House, but since EPS data represent profits earned up to two years earlier, this acceleration could not have been influenced by Trump’s election, let alone his policies. Similarly with the 2018 price drop: as the figure shows, the February market decline came after EPS fell in January 2018 (second vertical dotted line), and since most of the profits represented by January’s EPS were earned before Trump’s policies came into effect, they could not have been significantly influenced by those policies to start with.

The second implication is broader and much more important. According to the data, present-day capitalists seem to view the world much like the Aymara people of Southern Peru and Northern Chile do: with their back to the future. The Aymara language reverses the directional-temporal order of most other languages: it treats the known past as being ‘in front of us’ and the unknown future as lying ‘behind us’. [3] And judging by the Pearson correlation coefficient recorded in the bottom panel, capitalists do the same: since 1995, a full 46 per cent of the (squared) variations in the rate of change of stock prices can be explained by variations in the rate of change of past earnings.

This Aymara-like behaviour borders on sacrilege. According to finance textbooks, investors should look not backward, but forward. Their standard capitalization ritual, reiterated endlessly by the scientists of finance, conditions and compels them to discount not past profits, but future ones. Moreover, since corporations – and the capitalist system more generally – have no ‘expiry date’, their owners should look far beyond their immediate horizons. To properly price their assets, they must discount the profits they expect to earn not in the next few quarters or even several years, but all the way to ‘eternity’ (Benjamin Graham, quoted in Zweig 2009: 28).

But if so, why do present-day capitalists defy their most sacred ritual and, instead of peering into deep future, remain fixated on the immediate past?

3. The Radical Inversion

To complicate things further, according to Figure 2 this backward-looking posture is in fact rather new. As the bottom panel shows, until 1995 the cyclical growth rates of stock prices and EPS moved not together, but inversely: whereas the Pearson correlation between these rates was +0.46 in the post-1995 period, in the pre-1995 era it was –0.58. In other words, whatever affected the growth rate of stock prices from 1973 to 1995, it was not the growth rate of recent profits.

fig_02a_p_and_eps_us_2panes_till_1995.jpg
fig_02a_p_and_eps_us_2panes_till_1995.jpg (218.41 KiB) Viewed 108 times


This radical inversion is highly perplexing. Why would capitalists obey their rituals in one period only to ignore it in the next? What happened in the mid-1990s that made them shift from forward- to backward-looking asset pricing? What does this shift mean for the broader logic of capital accumulation? And what does it imply for the near future?

Continue reading: http://bnarchives.yorku.ca/534/15/20180 ... sp_web.htm

Endnotes

[1] Shimshon Bichler and Jonathan Nitzan teach political economy at colleges and universities in Israel and Canada, respectively. All of their publications are available for free on The Bichler & Nitzan Archives (http://bnarchives.net). Research for this paper was partly supported by the SSHRC. The article is licenced under Creative Commons (Attribution-NonCommercial-NvoDerivs 4.0 International).

[2] In this article, we use ‘earnings’ and ‘profits’ interchangeably.

[3] See Núñez and Sweetser (2006) and Pincock (2006). To test this inverted perception, just look up at the stars: ahead of you you’ll see nothing but the past.

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Continue reading: http://bnarchives.yorku.ca/534/15/20180 ... sp_web.htm
Jonathan Nitzan
 
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