The Reality Behind the Stock Market Success: Examining Earnings and Fundamentals

There’s a cohort of people who believe the stock market operates under questionable circumstances, assuming it’s a platform where only a select few prosper while others suffer losses. Some argue that the market is manipulated by external factors, leading to artificial outcomes. However, the presence of checks and balances in the system has proven advantageous for the economy and stock market over time.

Despite these safeguards, it is baseless to suggest that the stock market gains are rigged, counterfeit, or influenced. Earnings and fundamentals continue to play a significant role in the market’s success over the long term, as evidenced by the historical data showcasing the relationship between earnings and the S&P 500 index since the conclusion of World War II.

While there have been instances of prices outpacing fundamentals, the overarching trend indicates that stock prices surge primarily because of the growth in earnings. Dismissing the misconception that stock market gains solely stem from multiple expansion, it’s crucial to note that as markets evolve and become more secure, multiple expansion likely exerts a lesser impact than commonly assumed.

The late John Bogle‘s formula for anticipated stock market returns includes the dividend yield, earnings growth, and the change in the P/E ratio. Bogle’s analysis extended to each decade in the stock market’s history until the early 2000s, underscoring the disparity between fundamental expectations and actual returns, often impacted by human emotions.

Updating Bogle’s work into the 2010s and beyond reveals that, notwithstanding some multiple expansion, earnings growth remains the primary driver of stock market returns, particularly post the Great Financial Crisis. Analysis of the data through the end of 2023 aligns with this observation, illustrating the resilience of earnings growth in bolstering market performance.

Over the recent decades, although dividend yields have hovered at relatively low levels, the upward trajectory in dividends distributed by corporations has been robust. Post-2010, dividends have posted an annual growth rate exceeding 8%, underscoring the surge in dividend payouts despite the subdued yield environment.

Moreover, the escalation in U.S. corporate efficiency is a pivotal factor contributing to the stock market’s remarkable performance, evident in the consistent rise in profit margins following the Internet’s inception. The sustained uptrend in margins, disproving the notion that profit margins are inherently mean-reverting, underscores the transformative impact of technology stocks on market dynamics.

Looking beyond the U.S., the global landscape has witnessed a divergence in market performance, partly attributed to the exceptional fundamentals driving U.S. stock market success. While short-term market volatility persists due to fluctuating prices dictated by fear and greed, the long-term trajectory is shaped by robust fundamentals that tend to prevail over time.