Lots of readers are writing in to question my assertion that the stock market does not track corporate profits or GDP. They seem upset to learn that if you can correctly predict GDP growth or earnings growth in the short term that you can’t also predict the direction and magnitude of the market’s moves. The key here is that the market prices in certain expectations about the future ahead of time and then readjusts prices based on how the future plays out relative to those expectations. We cannot simply infer that, say, over the next year GDP will grow 3%, leading to earnings growth of 8%, and therefore the market will rise 8%. Markets are more complicated than that!
Here is an illustration I came up with to back up these claims (raw data compiled by NYU from Standard and Poor’s and Bloomberg). As you can see, correctly predicting S&P 500 earnings growth (grouped along the x-axis) for any given year does not help predict the market’s return (plotted along the y-axis) during that same year. In fact, the market does better when earnings are declining, relative to how it fares when earnings are growing by double digits. In the near future I will try and compile data that shows which figures actually have predictive value.