A Bull Market Built on Earnings Outshines One Driven by Emotion
The resilience of a bull market hinges on its foundation. A market rally anchored in strong earnings is fundamentally sturdier than one fueled by investor sentiment alone. Recent volatile trading patterns highlight this fragility. Take Nov. 19, for instance: the Dow Jones Industrial Average (DJIA) plummeted over 400 points at the opening bell but rebounded to end the day nearly flat. Such wild swings defy logical market fundamentals, pointing instead to the unpredictable nature of investor emotions.
Currently, the market appears to be mood-driven, which leaves the bulls on unstable ground. Consider the S&P 500: if its performance over the past five years had mirrored the growth in earnings per share, the index would sit below 4,500—roughly 25% lower than today’s level. Instead, the S&P 500 has surged past 5,900, driven by an expansion in price-to-earnings (P/E) ratios rather than proportional earnings growth.
Sentiment vs. Earnings
The relative influence of earnings and sentiment on the market depends largely on the time frame considered. David Rosenberg, founder of Rosenberg Research, analyzed the U.S. stock market‘s 41% gain over the past year against a mere 4% growth in earnings. Without the past year’s expansion in P/E multiples, Rosenberg estimates the S&P 500 would be closer to 4,600.
The way earnings are measured also shapes conclusions. Analysts may rely on trailing 12-month earnings, forward 12-month projections, or inflation-adjusted 10-year averages, as seen with Robert Shiller’s Cyclically Adjusted Price/Earnings (CAPE) ratio. Despite differences in methodology, the overarching trend remains consistent: the recent bull market has leaned heavily on widening P/E ratios.
The Role of Interest Rates
This reliance on inflated P/E multiples is even more precarious given the rising interest rate environment. Typically, higher interest rates lead to lower P/E multiples, as discounted cash flow models reduce the present value of future corporate earnings. Yet, despite the 10-year U.S. Treasury yield more than doubling over the past five years, P/E ratios have defied historical patterns, continuing to climb.
Had interest rates steadily declined during this period, the expansion in P/E ratios might seem more justifiable. Instead, today’s elevated multiples amplify market vulnerability, exposing the bull market’s reliance on sentiment rather than fundamentals.
The Bottom Line
Because investor sentiment is notoriously volatile, the stock market remains susceptible to sharp fluctuations like those seen earlier this week—or worse. A bull market driven by solid earnings growth would offer far greater stability than one riding on the whims of investor emotions.
