The stock market is making sense for the first time in 3 years

The most important drivers of stock prices are earnings and expectations for earnings growth. Earnings, or net income, is literally the bottom line.

So it surprises no one when stock prices fall as expectations for earnings growth decline.

This relationship, however, isn't always observable in the short-term. In fact, through most of this bull market we have seen stock prices actually go up despite earnings expectations coming down. This is a trend we have been keeping track of for years.

And according to Morgan Stanley's Adam Parker, the trend in earnings revisions has been negative since 1976, a period of time when stocks have trended higher.

But lately, the stock market has started to make intuitive sense again as we witnessed prices fall along with earnings estimates.

"During the first two months of the third quarter, analysts lowered earnings estimates for companies in the S&P 500 for the quarter," FactSet's John Butters said in a research note on Friday. "The Q3 bottom-up EPS estimate (which is an aggregation of the estimates for all the companies in the index) dropped by 2.7% (to $29.25 from $30.06) during this period."

"The value of the S&P 500 also declined during the first two months of the third quarter," Butters added.

"From June 30 through August 31, the value of the index decreased by 4.4% (to 1972.18 from 2063.11). This marked the first time since Q4 2012 that both the bottom-up EPS estimate and the value of the index fell during the first two months of a quarter. During the first two months of the previous ten quarters (Q113 – Q215), the value of the index increased while the bottom-up EPS estimate for the quarter decreased."

cotd sp500 price eps change

(FactSet)

In the long run, the relationship between stock prices and earnings seem to revert to long-term averages. This is good news for patient investors who are willing and able to ride out short-term swings in the market as they wait for value to come into fruition.

But in the short run, you're taking a big gamble trading on the assumption that these things work themselves out in a timely manner.

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